Optimal Taxation with Endogenous Insurance Markets∗

In this paper, we study optimal tax policy in a dynamic private information economy. We describe efficient allocations and competitive equilibria. The 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 and that government consumption can be financed by lump-sum taxation. We go on to 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. 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. ∗Golosov acknowledges support of the University of Minnesota Doctoral Dissertation Fellowship. This work grew out of numerous discussions with V.V. Chari and would not be possible without his support and encouragement. We thank Andy Atkeson, Marco Bassetto, Larry Jones, Patrick Kehoe, Robert Lucas, Jr., Lee Ohanian, Chris Phelan, Alice Schoonbroodt, Nancy Stokey for their comments. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.