Optimal Taxation with Endogenous Insurance Markets

We study optimal tax policy in a dynamic private information economy with endogenous private markets. We characterize efficient allocations and competitive equilibria. A standard assumption in the literature is that trades are observable by all agents. We show that in such an environment the competitive equilibrium is efficient. The only effect of government interventions is crowding out of private insurance. We then relax the assumption of observability of consumption and consider an environment with unobservable trades in competitive markets. We show that efficient allocations have the property that the marginal product of capital is different from the market interest rate associated with unobservable trades. In any competitive equilibrium without taxation, the marginal product of capital and the market interest rate are equated, so that competitive equilibria are not efficient. Taxation of capital income can be welfare-improving because such taxation introduces a wedge between market interest rates and the marginal product of capital and allows agents to obtain better insurance in private markets. Finally, we use plausibly calibrated numerical examples to compute optimal taxes and welfare gains and compare results to an economy with a restricted set of tax instruments, and to an economy with observable trades.

Designing Optimal Disability Insurance: A Case for Asset Testing

The paper analyzes an implementation of an optimal disability insurance system as a competitive equilibrium with taxes. The problem is modeled as a dynamic mechanism design problem in which disability is unobservable. We show that an asset-tested disability system in which a disability transfer is paid only if an agent has assets below a specified maximum implements the optimum. The logic behind the result is as follows: we show that an agent who falsely claims disability has higher savings than a truly disabled agent, and an asset test prevents false claimants from receiving disability. We also evaluate welfare benefits of asset testing. For a calibrated economy, we numerically compare the optimal system to the best system without asset testing. We find that gains of asset testing are significant and equal to about 0.65% of consumption.

A Theory of Asset Pricing Based on Heterogeneous Information

We propose a theory of asset prices that emphasizes heterogeneous information as the main element determining prices of different securities. Our main analytical innovation is in formulating a model of noisy information aggregation through asset prices, which is parsimonious and tractable, yet flexible in the specification of cash flow risks. We show that the noisy aggregation of heterogeneous investor beliefs drives a systematic wedge between the impact of fundamentals on an asset price, and the corresponding impact on cash flow expectations. The key intuition behind the wedge is that the identity of the marginal trader has to shift for different realization of the underlying shocks to satisfy the market-clearing condition. This identity shift amplifies the impact of price on the marginal trader's expectations. We derive tight characterization for both the conditional and the unconditional expected wedges. Our first main theorem shows how the sign of the expected wedge (that is, the difference between the expected price and the dividends) depends on the shape of the dividend payoff function and on the degree of informational frictions. Our second main theorem provides conditions under which the variability of prices exceeds the variability for realized dividends. We conclude with two applications of our theory. First, we highlight how heterogeneous information can lead to systematic departures from the Modigliani-Miller theorem. Second, in a dynamic extension of our model we provide conditions under which bubbles arise.

Optimal Dynamic Taxes Mikhail Golosov

We study optimal labor and savings distortions in a lifecycle model with idiosyncratic shocks. We show a tight connection between its recursive formulation and a static Mirrlees model with two goods, which allows us to derive elasticity-based expressions for the dynamic optimal distortions. We derive a generalization of a savings distortion for non-separable preferences and show that, under certain conditions, the labor wedge tends to zero for su ¢ ciently high skills. We estimate skill distributions using individual data on the U.S. taxes and labor incomes. Computed optimal distortions decrease for su ¢ ciently high incomes and increase with age

Markets Versus Governments: Political Economy of Mechanisms

We study the optimal Mirrlees taxation problem in a dynamic economy with idiosyncratic (productivity or preference) shocks. In contrast to the standard approach, which implicitly assumes that the mechanism is operated by a benevolent planner with full commitment power, we assume that any centralized mechanism can only be operated by a self-interested ruler/government without commitment power, who can therefore misuse the resources and the information it collects. An important result of our analysis is that there will be truthful revelation along the equilibrium path (for all positive discount factors), which shows that truth-telling mechanisms can be used despite the commitment problems and the different interests of the government. Using this tool, we show that if the government is as patient as the agents, the best sustainable mechanism leads to an asymptotic allocation where the aggregate distortions arising from political economy disappear. In contrast, when the government is less patient than the citizens, there are positive aggregate distortions and positive aggregate capital taxes even asymptotically. Under some additional assumptions on preferences, these results generalize to the case when the government is benevolent but unable to commit to future tax policies. We conclude by providing a brief comparison of centralized mechanisms operated by self-interested rulers to anonymous markets.