We study optimal capital taxation in a limited commitment environment. Our
environment consists of a continuum of households with idiosyncratic labor shocks,
who have access to a complete contingent claims market. Financial contracts are not
perfectly enforceable; as in Kehoe and Levine (1993), enforcement constraints take
the form of endogenous debt limits. This market imperfection drives the endogenous
discrepancy between the household and planner discount factors: households face the
possibility of being debt constrained in the future, and as a result have a higher discount
factor than the planner, who does not face such a constraint. In such an economy,
the planner will choose an optimal capital level that is lower than that chosen by
households; this diÂ¤erence in the choice of capital motivates imposing a positive capital
income tax on households to induce them to invest at the socially optimal amount
Capital Tax, borrowing constraint, enforcement
We study optimal capital income taxation with a Ramsey problem and relate this optimal taxation problem to the question that has been asked in the asset pricing literature, which is why the risk free interest rate is too low. We show that the Ramsey planner chooses the optimal level of capital stock to be one that satisfies the modified golden rule in the steady state under some conditions. The conditions include sufficient government tax instruments and ability to issue bonds. We argue that the optimal capital level is different from that chosen in a competitive equilibrium unless the competitive equilibrium risk free interest rate is same as the time discount rate in the steady state. This difference in the choice of capital motivates imposing a positive capital income tax (or subsidy) on households to induce them to invest at the socially optimal amount. As examples, we investigate optimal capital taxation in a decentralized economy with limited commitment and one with private information. However, the result still holds in various types of economies with risk free interest rate that is too low.
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