Constrained Efficient Taxation of Capital

I show in this paper that in an overlapping generations economy with production à la Diamond (1965) in which the agents can only save in terms of physical capital, the laissez-faire competitive equilibrium steady state is not only typically inefficient among all feasible steady states the economy may start from, but it is even ”constrained inefficient”, that is to say, dominated by other steady states the economy may start from and that are attainable through the existing markets (for the consumption good and the factors of production). The reason is that if the agents of a same generation were able to coordinate their saving decisions in order to manipulate the future return to their own savings, they could improve upon the competitive outcome by departing from their competitive choices. Such a coordination is of course impossible under competitive conditions. Nevertheless, the ”constrained efficient” steady state can be implemented as a competitive outcome, if the economy starts there, by a government following an active fiscal policy that taxes or subsidizes linearly the returns to savings while balancing the budget period by period through a lump-sum transfer or tax, respectively, on second period income. Each period tax/subsidy rate and lump-sum transfer/tax is moreover determined as a function of past saving decisions. Note finally that this policy does not finance any public spending, since there is none in the model. The only purpose of the intervention is to make possible to implement in a decentralized way as a competitive equilibrium the constrained efficient steady state that maximizes the utility of the representative agent among all the steady state allocation attainable through the ”real” markets.