In the design of an optimal tax-transfer system, there are two complementary conventional wisdoms: the labor-efficiency argument and the debt-efficiency argument. The former emphasizes the trade-off between redistribution and distortions in the labor market, while the latter emphasizes the trade-off between gains from monopoly rents and distortions in the asset market. We use an analytically tractable infinite-horizon model with both ex-ante and ex-post heterogeneity to show that neither argument is complete in the design of the tax-transfer system. Instead, in Aiyagari-type models the optimal system should be determined at the point where the intertemporal wedge between the market interest rate and the time discount rate is completely eliminated, provided that the government fiscal space permits an interior Ramsey steady state. Otherwise the optimal labor tax rate approaches 100% regardless of the Pareto weight distribution in the social welfare function.
https://doi.org/10.20955/wp.2023.009
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