Taxation, redistribution, and debt in incomplete market economies with aggregate shocks

We study an incomplete market economy with aggregate shocks and agents with heterogeneous skills. To redistribute and to finance exogenous stochastic government expenditures, the government imposes non-linear taxes on labor income. Only relative assets positions determined, so assets of the government or one of the agents can be set to zero always. Optimal labor distortions are history dependent but do not necessarily to drift to zero. Optimal labor distortions and debts in a heterogenous agent economy differ markedly from representative agent models like Aiyagari et al (2002). Differences stem from the restriction that lump sum transfers are non-negative in those representative agent economies, a restriction that we do not impose. In representative agent economies, the binding non-negative lump sum transfers restriction determines dynamics of distorting taxes and government debt. If that restriction were imposed in our heterogenous agent economy, it would not necessarily bind. We thank Mark Aguiar, Anmol Bhandari, David Evans, and Ali Shourideh for helpful comments. We thank Anmol Bhardari and David Evans for excellent help with the computations.