Insurance and Taxation over the Life Cycle
Author(s)Werning, Ivan; Farhi, Emmanuel
MetadataShow full item record
We consider a dynamic Mirrlees economy in a life-cycle context and study the optimal insurance arrangement. Individual productivity evolves as a Markov process and is private information. We use a first-order approach in discrete and continuous time and obtain novel theoretical and numerical results. Our main contribution is a formula describing the dynamics for the labour-income tax rate. When productivity is an AR(1) our formula resembles an AR(1) with a trend where: (i) the auto-regressive coefficient equals that of productivity; (ii) the trend term equals the covariance productivity with consumption growth divided by the Frisch elasticity of labour; and (iii) the innovations in the tax rate are the negative of consumption growth. The last property implies a form of short-run regressivity. Our simulations illustrate these results and deliver some novel insights. The average labour tax rises from 0% to 37% over 40 years, whereas the average tax on savings falls from 12% to 0% at retirement. We compare the second best solution to simple history-independent tax systems, calibrated to mimic these average tax rates. We find that age-dependent taxes capture a sizable fraction of the welfare gains. In this way, our theoretical results provide insights into simple tax systems.
DepartmentMassachusetts Institute of Technology. Department of Economics
The Review of Economic Studies
Oxford University Press
Farhi, E., and I. Werning. “Insurance and Taxation over the Life Cycle.” The Review of Economic Studies 80, no. 2 (April 15, 2013): 596-635.
Author's final manuscript