Capital Taxation with Entrepreneurial Risk

This paper studies the effects of capital taxation in a dynamic heterogeneous-agent economy with uninsurable entrepreneurial risk. Although it allows for rich general-equilibrium effects and a stationary distribution of wealth, the model is highly tractable. This permits a clear analysis, not only of the steady state, but also of the entire transitional dynamics following any change in tax policies. Unlike either the complete-markets paradigm or Bewley-type models where idiosyncratic risk impacts only labor income, here it is shown that capital taxation may actually stimulate capital accumulation. This possibility emerges because of the general-equilibrium effects of the insurance aspect of capital taxation. In particular, for the preferred calibrated version of the model, when the tax on capital is 25%, aggregate output is 2.5% higher than what it would have been had the tax rate been zero. Turning to the welfare effects of a reform in capital taxation, it is shown how these effects depend on whether one focuses on the steady state or also takes into account transitional dynamics, as well as how they vary in the crosssection of the population (rich versus poor, entrepreneurs versus non-entrepreneurs). ∗MIT Department of Economics, Email address: [email protected]. I am deeply indebted to my primary advisor, George-Marios Angeletos, for his constant support and guidance. I am very grateful to my advisors Mike Golosov and Ivan Werning for extremely constructive feedback and discussions. I would like to thank Daron Acemoglu, Olivier Blanchard, Sylvain Chassang, Peter Diamond, Simon Gilchrist, Jiro Kondo, Dimitris Papanikolaou, James Poterba, Catarina Reis, Robert Townsend, Harald Uhlig and seminar participants at MIT for useful comments.