Finance and Economics Discussion Series

Capital Taxation with Entrepreneurial Risk

Vasia Panousi
2010-56

Abstract: 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 percent, output per work-hour is 2.2 percent higher than it would have been had the tax rate been zero. Turning to the welfare effects of a reform in capital taxation, it is examined 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 cross-section of the population (rich versus poor, entrepreneurs versus non-entrepreneurs).

Keywords: Capital-income taxation, uninsurable idiosyncratic investment risk, general equilibrium, heterogeneous agents