Optimal Taxation of Entrepreneurial Capital and Financial Assets with Private Information

National Science Foundation, SES-061774
Principal Investigator: Stefania Albanesi



The purpose of this project is to study the optimal taxation of entrepreneurial capital and financial assets in private information economies. The optimal setting of taxes on capital income is a classic question in macroeconomics and public finance. The interest in entrepreneurial capital is motivated by the observation that this form of capital accounts for a disproportionately large fraction of household wealth in the US economy. The investigator maintains that the main source of risk for entrepreneurs is capital risk and that incentive problems due to informational frictions play a central role in entrepreneurial activity. To characterize the optimal tax system, she first derives the constrained Pareto optimal allocation given the informational frictions, and then constructs a set of taxes that implements such an allocation. The resulting tax system optimizes the trade-off between insurance and incentives. The private information determines a wedge between the marginal benefit of an additional unit of wealth and the marginal utility of current consumption at the constrained Pareto optimal allocation. The preliminary work derives an important result: this intertermporal wedge can be negative for entrepreneurial capital and, in this case, the optimal marginal capital tax is progressive. By contrast, in private information economies with labor income risk, the intertemporal wedge is always positive and the optimal marginal asset tax is regressive. This project illustrates the different incentive effects of capital and other assets that underpin this result and also give rise to a prescription for differential asset taxation. The proposed new work will extends the current analysis in a number of directions. Theoretically, the investigator plans to derive general conditions under which the intertermporal wedge on entrepreneurial capital is negative and explore the implications for the limiting distribution of consumption. We will analyze optimal taxes for market structures that allow for private contracts between entrepreneurs and other agents in the economy. She also plans to conduct a quantitative analysis of optimal tax systems, using microeconomic data on entrepreneurial earnings to calibrate capital risk.

The intended contribution of this study is twofold. The focus on economies with capital risk provides novel insights on the dynamic distortions resulting from informational frictions and, potentially, for long run inequality. As is well known, in economies with labor income risk optimal allocations display decreasing consumption over agents' lifetime and generally predict that consumption and wealth inequality should grow without bound. The project explores positive effects of capital on entrepreneurial incentives that may temper these extreme implications. This investigator is also the first to propose a theory of differential asset taxation based on informational frictions. This does not arise in economies with labor income risk, where the qualitative properties of optimal capital income taxes do not depend on the nature of the asset. Finally, the joint predictions for optimal allocations and taxes can provide the basis for a more realistic quantitative analysis that could enable a comprehensive assessment of actual systems of taxation of household wealth in comparison with the optimal ones.

Broader Impacts The results of this study will be of interest to researchers focusing on dynamic mechanism design, given the novelty of the incentive problem with capital risk, as well as to researchers in macroeconomics and in public finance. Moreover, given the ongoing public debate on tax reform in the US and in other countries, the findings from this project will naturally be interesting for policymakers. The research will also be integrated with the investigator's teaching, especially at the graduate level. It is expected that graduate research assistants will be introduced to important research skills and potential research topics to develop on their own.



Working Papers and Publications

Stefania Albanesi, 2006. 'Optimal Taxation of Entrepreneurial Capital with Private Information'. CEPR Discussion Paper no. 5647. London, Centre for Economic Policy Research.
NBER Working Paper 12419: http://www.nber.org/papers/w12419