Taxation, redistribution, and debt with aggregate shocks

We study optimal income taxes and transfers in an economy with heterogeneous agents and aggregate shocks. An optimal equilibrium determines agents’ net asset positions, but not their absolute levels. The distribution of debt holdings across agents influences optimal allocations and taxes, but the level of government debt does not. Higher correlations of debt holdings and labor incomes imply more distortions and lower welfare. In incomplete markets economies, the government has no precautionary incentive to accumulate assets to smooth government expenditures, an outcome that implies different optimal taxes and government debt than representative agent Ramsey models like Aiyagari et al. (2002). Imposing exogenous borrowing constraints can actually increase welfare. When markets are incomplete, the government optimally responds to an increase in government expenditures by increasing taxes and decreasing transfers. These responses are persistent and history dependent. We thank Mark Aguiar, Anmol Bhandari, V.V. Chari, David Evans, Guy Laroque, Robert E. Lucas, Jr., Ali Shourideh, and seminar participants at Bocconi, Chicago, EIEF, the Federal Reserve Bank of Minneapolis, Princeton, and UCL for helpful comments. We thank Anmol Bhandari and David Evans for excellent help with the computations.