Optimal Taxation in Infinitely-Lived Agent and Overlapping Generations Models: A Review

T he literature concerned with dynamic fiscal policy has evolved in two main directions over the last 20 years or so. On the one hand, there is a large literature on optimal taxation. In the context of a standard neoclassical growth model with infinitely-lived individuals, Chamley (1986) and Judd (1985) establish that an optimal income-tax policy entails taxing capital at confiscatory rates in the short run and setting capital income taxes equal to zero in the long run. Only labor income should be taxed in the long run. On the other hand, most applied work concerned with the dynamic impact of fiscal policy uses the life-cycle framework (Auerbach, Kotlikoff, and Skinner [1983], Auerbach and Kotlikoff [1987], and many others, surveyed in Kotlikoff [1998]). Unfortunately, the prescriptions that emanate from the former framework do not necessarily generalize to the latter. This article reviews the basic results obtained under both the infinitelylived agent model and the life-cycle model. The first section, which presents a nontechnical introduction to the optimal taxation literature, discusses the optimal taxation problem and the intuition behind the results obtained from both types of models. Section 2 more formally presents the results for the infinitely-lived agent model and Section 3 presents results for the life-cycle economy. The review of the literature presented here complements that of Chari and Kehoe (1999) and Atkeson, Chari, and Kehoe (1999). The main focus of their