The Taxation of Capital Returns in Overlapping Generations Economies without Financial Assets

I show in this paper that in an overlapping generations economy with production à la Diamond (1970) in which the agents can only save in terms of capital (i.e. with no asset bubbles à la Tirole (1985) or public debt as in Diamond (1965)), there is a period-by-period balanced fiscal policy supporting a steady state allocation that Pareto-improves upon the laissez-faire competitive equilibrium steady state (without having to resort to intergenerational transfers) if there is no first generation or the economy starts there. A transition from the competitive equilibrium steady state to this other allocation is also Pareto-improving if the former is dynamically inefficient, but even in the dynamically efficient case if the elasticity of output to capital is high enough. This intervention allows every subsequent generation to attain, as a competitive equilibrium outcome, the highest utility attainable at a steady state through the existing markets for the consumption good and the production factors. The active fiscal policy consists of taxing (or subsidizing, in the dynamically efficient case) linearly the returns to capital, while balancing the budget period by period through a lump-sum transfer (or tax, respectively) on second period income. This policy does not finance any public spending, since there is none in the model. The only purpose of the intervention is to decentralize as a competitive equilibrium the steady state allocation that maximizes the utility of the representative agent among all steady state allocations attainable through the existing markets. An earlier version of this paper has circulated under the title ”Constrained Efficient Taxation of Capital”. I thank useful feed-back and discussions with David de la Croix, Hippolyte d’Albis, Jacques Drèze, Roger Guesnerie, Peter Hammond, Alain Venditti, and attendants to the Public Economic Theory 08 conference in Seoul, the XVII European Workshop in General Equilibrium Theory held in Paestum (Italy), and the Workshop ”Growth with heterogeneous agents: causes and effects of inequality” held in GREQAM Marseille (France) in 2008. Typeset by AMS-TEX 1 ha ls hs -0 03 48 92 3, v er si on 1 22 D ec 2 00 8