Abstract:

My dissertation focuses on the consequences of imperfect financial contracts on policy. In particular, I study optimal capital taxation in an environment where financial contracts are not perfectly enforceable. In this environment, I couple a model of limited risk sharing with optimal policy analysis; this allows me to address the important policy implications of imperfect financial contracts.

In Chapter 2, Why Tax Capital?, I argue that positive capital tax is optimal in the long run, contrary to the traditional Ramsey argument of zero capital taxation. The imperfect enforceability of financial contracts gives rise to endogenous debt limits in the form of enforcement constraints, i.e. households cannot accumulate more debt than they are willing to pay in the future. This imperfect financial contract drives an endogenous discrepancy between private sector 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 the private sector; this difference in the choice of capital motivates the imposition of a positive capital income tax on the private sector, which in turn induces it to invest at the socially optimal level.

In Chapter 3, I investigate the externality of capital investment that arises in the economy with imperfect enforceability of financial contracts where the government plays only a minimal role: it collects tax revenue and simply transfers it back to households in a lump-sum fashion. We assume that households only consume their wage income when they default. Capital investment increases the value of autarky by raising the wage rate, which in turn increases the incentives to default and this is costly in terms of Pareto efficiency. This externality cost provides a rational for positive capital taxation even in the absence of government expenditure. Moreover, we show that both this externality cost of capital investment and the optimal capital tax rate are potentially much bigger than one might expect.