Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks

We evaluate the optimal fiscal policy in a standard incomplete-markets model with uninsurable idiosyncratic shocks, where a Ramsey planner chooses time-varying paths of proportional capital and labor income taxes, lump-sum transfers (or taxes), and government debt. We find that: (1) short-run capital income taxes are effective in providing redistribution since the tax base is relatively unequal and inelastic; (2) an increasing pattern of labor income taxes over time mitigates intertemporal distortions from capital income taxes; (3) the optimal policy expands the US social welfare system significantly, increasing overall transfers by roughly 50 percent; (4) two thirds of the welfare gains come from redistribution and the remaining third come mostly from insurance; and (5) redistribution also leads to a more efficient allocation of labor via wealth effects on labor supply—lower productivity households can afford to work relatively less.