Comments on “Optimal Capital Taxation with Idiosyncratic

Investment Risk”By Vasia Panousi and Catarina Reis

Haiping Zhang

Singapore Management University

43. Konstanz Seminar

23 May 2012

Related Literature:1. Idiosyncratic income risk and incomplete markets

2. Uninsured income risk and optimal taxation

Ramsey Approach (Insurance)

Mirrlees Approach (insurance vs. Incentive)

Aiyagari (1995), Chamley (2001)

Golosov et. al (2003), Albanesi and Sleet (2006), Golosov et. al. (2010), Golosov et. al. (2011), Fahri and Werning (2010)

Labor income risk

Capital income risk

Aiyagari (1994), Hugget (1993, 1997), Krusell and Smith (1998)

Angeletos and Calvet (2005.2006), Angeletos (2007), Buera and Shin (2007), Cagetti and De Nardi (2006), Meh and Quadrini (2006)

Benhabib, Bisin, Zhu (2011, ECTA)

Main Features:1. A continuous-time heterogeneous-agent model

idiosyncratic capital income risk and no aggregate uncertainty

2. Homothetic preference and CRS production

3. Redefine the net wealth of household i from the lifetime perspective

Risk-free asset:rate of return: Rt

Risky asset:Riskiness: Mean rate of return: rt

Financial wealth Human wealth

Model Solution:1. Sameulson-Merton optimal portfolio choice (Angeletos, 2007)

2tt

σR-r

t =

Risky investment:

Risk-free investment:

Portfolio share:

Model Solution:

Angeletos and Panousi (2009)

Risk premium required

Precautionary saving

Capital and bonds are perfect substitutes

In the steady state

Complete markets: Deterministic at the aggregate and the individual levels

Incomplete markets: Deterministic at the aggregate level and stochastic at the individual level

If markets cannot provide sufficient private risk-sharing, the government may step in to provide additional public risk sharing in the form of proportional capital income tax.

Impacts of Proportional Capital Income Tax

Insurance effect

The general equilibrium effect:

Intertemporal wedge

Comments1. How do macro aggregates and the welfare of an “average” household respond

to capital income tax during the transitional process?

• upon the policy announcement

• the medium-run adjustment

• the long-run level

The optimal implementation schedule

2. Endogenous incomplete markets

• Strategic default on risk-free bond

• Interactions between public and private risk sharingCrowd-in or crowd-out private risk-sharing (Krueger, et. al. 2011)

• Fundamental causes of limited risk sharing in the private markets

Conclusion1. Very elegantly written and intuitively inspiring

2. Serves as a benchmark for further quantitative analysis

3. Opens a door for the research on a variety of topics

optimal taxation in the presence of cross-sector differences in uninsured risk“Plants in the most volatile sector are subject to at least three times as much uncertainty as plants in the least volatile.” – Castro, Clementi, and Lee (2011)

Endogenous project adoptionwill the public Insurance encourage the adoption of the inherently riskier but more productive projects?

The extensive margin of investment: entrepreneurial entry and exit