Pareto-Improving Optimal Capital and Labor Taxes

Abstract

We study optimal Pareto-improving fiscal policy in a model where agents are heteroge- neous in their labor productivity and wealth and markets are complete. We first argue that recent results that find positive optimal long-run capital taxes in standard models obtain only if the government is allowed to immiserate the economy or if the government would prefer to waste consumption. Excluding these possibilities the Chamley-Judd result reemerges. We find that the long-run optimal tax mix is the opposite of theci short- and medium-run. For a Pareto improvement the length of the transition is very long, more so for policies that benefit the poor. Therefore the traditional focus on long-run optimal taxes is unwarranted. An initial labor tax cut causes early deficits leading to a positive level of government debt in the long run. Welfare weights need to be found endogenously for a Pareto improvement, a Benthamite policy that weighs equally all agents is often not Pareto improving. The optimal fiscal policy is time-consistent if re- optimization requires consensus and heterogeneity is high. We address the sufficiency of first-order conditions for the Ramsey optimum and provide a solution algorithm.