Essays on optimal taxation and constrained efficiency

This dissertation consists of three essays that study optimal design of government policies in economies with financial frictions. The first and second essays concern the optimal tax policies when perfect consumption insurance against idiosyncratic income risk is inhibited by different types of market frictions, namely limited commitment and incomplete market, respectively. The third essay extends the analysis on optimal government policies to the optimal sovereign debt policy. Chapter 1 studies optimal Ramsey taxation when risk sharing in private insurance markets is imperfect due to limited enforcement. In a limited commitment economy, a Ramsey government who designs optimal tax policies has an additional goal of improving private consumption insurance in addition to its usual goal - minimizing distortions in financing government expenditures, because there are externalities associated with capital and labor which can be internalized by the tax policies to improve private insurance. It is shown that the steady-state optimal capital income taxes are levied only to remove the negative externalities of capital, whereas optimal labor income taxes are set to meet the budgetary needs of the government in the long run, despite the presence of positive externalities of labor. Chapter 2 analyzes constrained efficient allocation in an Aiyagari (1994) style of standard incomplete market with human capital accumulation. I especially focus on how the implication of pecuniary externalities can be changed as human capital accumulation is introduced. In standard incomplete market model with exogenous labor income shock, pecuniary externalities tend to imply that capital in a competitive equilibrium is underaccumulated. I analytically show that by introducing risky human capital accumulation, this implication can be overturned qualitatively from under to over accumulation, even though a quantitative investigation shows that the quantitative result is not reversed. Chapter 3 studies optimal sovereign debt policy of the government with limited commitment and compares the optimal policies in economies with and without government\u27s capital control. I show that the optimal sovereign debt policies in open economies without capital control generates more negative relationship between growth and public capital flows, which is observed in the data