Economics Webinar - Pareto-Improving Optimal Capital and Labor Taxes

We study optimal Pareto-improving fiscal policy in a model where agents are heterogeneous in their labor productivity and wealth and markets are complete. We first argue that recent results that find positive optimal long-run capital taxes in standard models largely occur when a government desires to immiserate the economy or in environments where the government would prefer to waste consumption. In the model we consider, excluding these possibilities the Chamley-Judd result reemerges. We find that the long-run optimal tax mix is the opposite of the short- and medium-run. For a Pareto improvement the length of the transition is very long, more so for policies that benefit the poor. Therefore the traditional focus on long-run optimal taxes is unwarranted. An initial labor tax cut causes early deficits leading to a positive level of government debt in the long run. Welfare weights need to be found endogenously for a Pareto improvement, a Benthamite policy that weights equally all agents is often not Pareto improving. We address the sufficiency of first-order conditions for the Ramsey optimum and provide a solution algorithm.