Skip to main content Skip to main content

Implementing the Modified Golden Rule? Optimal Ramsey Capital Taxation with Incomplete Markets Revisited

What is the prescription of Ramsey capital taxation in the long run? Aiyagari (1995) addressed the question in a heterogeneous-agent incomplete-market (HAIM) economy, showing that a positive capital tax should be imposed to implement the so-called modified golden rule (MGR). This famous capital taxation result is built on a critical assumption that a Ramsey steady state (featuring the non-binding of the government’s natural debt limit) exists. This paper revisits and checks the validity of this critical assumption. We first show that an optimal Ramsey allocation may feature no steady state if the government’s natural debt limit never binds. Hence, the Ramsey steady state described and assumed by Aiyagari (1995) turns out to be incorrect. We further show that any steady state of the HAIM economy can be welfare-improved by issuing more government bonds to front-load consumption. The key to both results is embedded in the hallmark of the HAIM economy that the steady-state risk-free rate is lower than the time discount rate in competitive equilibrium. On the basis of our findings, we argue that the most likely long-run Ramsey outcome should feature the co-existence of a Ramsey steady state with (i) the binding of the government’s debt limit and (ii) the failure of the MGR.

Read Full Text

Subscribe to our newsletter

Back to Top