Constrained Ine¢ ciency and Optimal Taxation with Uninsurable Risks

When individuals’ labor and capital income are subject to uninsurable idiosyncratic risks, should capital and labor be taxed, and if so how? In a two period general equilibrium model with production, we …rst show that reducing investment is welfare improving if households are homogeneous enough ex ante. On the other hand, when the degree of heterogeneity is su¢ ciently high a welfare improvement is achieved by increasing investment, even if the investment level is already higher than at the e¢ cient allocation obtained when full insurance markets were available. Consequently, the optimal capital tax rate might be negative. We derive a decomposition formula of the e¤ects of the tax which allow us to determine how the sign of optimal tax on capital and labor depends both on the nature of the shocks and the degree of heterogeneity among consumers as well as on the way in which the tax revenue is allocated. (JEL codes: D52, H21.