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Aiyagari Meets Ramsey: Optimal Capital Taxation with Incomplete Markets

What is the prescription of Ramsey capital taxes for Aiyagari’s (1994) incomplete-markets economy in the steady state? Departing from the endogenous setting in Aiyagari (1995), this paper answers the question by considering an exogenous stream of government purchases as in the canonical Ramsey problem. The departure makes the planner’s Euler equation involve the whole distribution of agents’ consumption, which is absent in Aiyagari (1995). By imposing the “measurability condition” to account for the incompleteness of markets, we are able to apply the primal approach to analytically solve for the Ramsey problem of the Aiyagari (1994) economy. It is shown that capital should be taxed in the steady state to implement the modified golden rule, although this result may not hold for economies inflicted by different frictions. We also address the transitional dynamics, showing that capital should be taxed all the time during transition if the elasticity of intertemporal substitution is not elastic. Our findings differ from those in Davila, Hong, Krusell, and Rıos-Rull (2012) and we explain why the differences arise.

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DOI: 10.20955/wp.2017.003

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