Optimal taxation in dynamic general equilibrium

Abstract

This thesis addresses the issue of optimal choice of income tax rates for a benevolent government (the Ramsey problem) in variants of multi-sector dynamic general equilibrium models.  Using the primal approach to taxation, the thesis recasts the optimal taxation problem as one in which the choice variables for the government are allocations rather than tax rates.  Permissible allocations are those that satisfy resource constraints and implementability constraints, where the latter are budget constraints in which the consumer and firm first order conditions are used to substitute out for prices and tax rates.

There are five chapters in this thesis.  Chapter one sets the tone of the thesis by introducing the Ramsey problem and the current state of the art in dynamic Ramsey taxation.  This chapter is a detailed review of existing literature, ongoing trends, and established models and results of dynamic Ramsey taxation in representative agent economies.

Chapter two solves the Ramsey problem in a simple infinite-horizon two-sector neoclassical production economy where the two sectors produce consumption goods and new capital goods, both tradable in competitive markets.  The startling finding of this chapter is that the celebrated result of long run zero capital income tax does not hold unconditionally for a wider class of neoclassical production economy models.  The chapter prescribes that capital income can be taxed at a nonzero rate in the consumption goods sector as long as the other capital income tax is set at zero.  It also shows that an ex ante restriction of identical income tax rates across sectors results in nonzero capital income tax.

Chapter three and four solve the Ramsey problem in environments characterized by monopoly power in private markets.  Chapter three addresses the issue of optimal labor income taxation in an economy without capital, and establishes that the optimal policy involves a lower labor income tax which offsets the distortions created by monopoly pricing.  An extension with monopolistic wage setting is also presented.  Chapter four develops a model with private market distortions and a richer set of income taxes which include sector-specific labor income taxes, profit tax and capital income tax.  The main finding of this chapter is that the optimal levels of sector-specific labor income tax are not equal (with lower tax in sector with monopoly pricing), and optimal steady state capital income tax is nonzero.  The sign of the optimal capital income tax depends on the relative strength of two opposing effects, namely, the welfare effect of investment, and the monopoly distortion effect.  Both these chapters present numerical results based on calibration of the models to fit stylized facts of the post war US economy.

Chapter five is devoted to examining the policy relevance of Ramsey tax rules.  It defends the established Ramsey tax rules and the key results derived in this thesis against the commonly held criticisms, which are typically based on practicality, efficiency, administrative costs and fairness.

The thesis belongs to a stream of literature that addresses optimal fiscal policy issue in a class of dynamic general equilibrium models.  It is therefore particularly intended to contribute to macroeconomic and public economic theory research.

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