Professor John Hassler, IIES, Stockholm University.

A course in Optimal Dynamic Tax and Social Insurance Policy¹

This course will cover some important results and models in the area of public finance. The object of study is shared with “standard” public finance courses – we will analyze how to provide social insurance and impose taxes in an welfare maximizing way. In some contrast, however, we will focus on dynamic issues and use a macroeconomist's perspective.

The first topic will deal with optimal unemployment insurance in a setting where individuals can choose how actively to search for a job. The government can observe the employment status of the individual but not how much search effort he exercise. The government wants to maximize the utility of the individuals but face the moral hazard problem that with too generous benefits, the search activity will be too low. A benchmark in the discussion will be the now classic result by Shavell& Weiss and Hopenhayn&Nicolini that if individuals have no hidden access to capital markets, unemployment benefits should decline over the unemployment spell. We will then discuss how sensitive this result is to alternative assumptions about, e.g., access to capital markets.

The second topic will deal with optimal taxation in a dynamic macro setting – the Ramsey problem. Also here, there will be a moral hazard problem. Individuals are allowed to privately choose how much to work and consume. If lump sum taxes are assumed away, taxation will be distortionary and the issue is to analyze how these distortions can be minimized. Our discussion will be centered around another classic result by Chamley and Judd, namely that if the government has access to both capital and labor income taxes, it should only use labor income taxes after a short initial period with positive capital income taxes. This results is more general than one might think, but of course not insensitive to all assumptions.

The final topical will start with a classic model in static public finance – the Mirrless model. Also here, the issue is about how to set taxes to maximize aggregate welfare. The important difference is that individuals here are different in terms of their ability – there is a distribution of individual productivity levels in the economy and the government can only observe the income of the individual. We could think that highly productive individuals need to put in some effort to really exploit their potential and if they don't they look just like any ordinary individual. The Mirrless problem is to analyze how to optimally construct an income tax in such an economy with such an informational friction. In contrast to the Ramsey problem, no restrictions are imposed on the characteristics of the tax schedule. An important result (that came as a negative surprise to Mirrless) is that marginal income taxes should be lowest at the top, limiting the ability to redistribute from rich to poor. Very recently, the Mirrless model has been extended to a dynamic setting. This emerging literature has been called the “New Dynamic Public Finance” and we will try to get some taste bits of it.

Requirements:

1 Introductory graduate macroeconomics.

2 Dynamic optimization – knowledge of standard dynamic programming.

Notes:

I will follow fairly my fairly extensive notes during the course. It is likely to be useful to print and bring the notes to class. Notes are here in (pdf) and as a SciWord texfile

The following is a preliminary description of the plans for the course. Starred articles are strongly recommended reading but the lectures will be self-contained and do not require that students have read the articles in advance. I stress the the list of articles is preliminary and may change.

Topic 1. Optimal unemployment insurance (UI)

1. The Dynamic approach with observable savings

· Baily, Martin Neil, (1978) “Some Aspects of Optimal Unemployment Insurance”, Journal of Public Economics, December 1978, pp. 379-402

·* Ljungqvist, Lars and Thomas J. Sargent, “Recursive Macroeconomic Theory”, Chapter 21, Second Edition, MIT Press

·*Shavell, S. and Weiss, L.: 1979, “The optimal payment of unemployment insurance benefits over time”, Journal of Political Economy 87(6), 1347–1362.

·*Hopenhayn, H. A. and Nicolini, J. P.: 1997, “Optimal unemployment insurance”, Journal of Political Economy 105(2), 412–438.

· Hopenhayn, H. A. and Nicolini, J.P., 2005, “Optimal Unemployment Insurance and Employment History”, mimeo.

· Rendahl, Pontus, 2007, “Asset Based Unemployment Insurance”, mimeo, EUI.

· Pavoni, Nicola and Gianluca Violante, 2007, “Optimal Welfare-to-Work Programs”, Review of Economic Studies,74, 283–318

2. The Dynamic approach with unobservable savings

· *Shimer, Robert and Ivan Werning, 2005, “Liquidity and insurance for the unemployed” NBER Working Paper 11689.

·* Hassler, John and J.V. Rodriguez Mora, 2008, “Unemployment Insurance Design: how to induce moving and retraining” , European Economic Review, 52: 5, July 2008, pp. 757-79

Topic 2. Optimal taxation – the Ramsey approach

1. Optimal taxation under commitment – the Ramsey problem

· * Ljungqvist, Lars and Thomas J. Sargent, “Recursive Macroeconomic Theory”, Chapter 15, Second Edition, MIT Press

· *Chamley, Christophe, 1986. “Optimal taxation of capital income in general equilibrium with infinite lives”, Econometrica 54 (May): 607–22

· *Judd, Kenneth L. 1985, “Redistributive taxation in a simple perfect foresight model”, Journal of Public Economics 28 (October): 59–83

· *Atkeson, Andrew; Chari, V. V., and Kehoe, Patrick J., “Taxing Capital Income: A Bad Idea”, Federal Reserve Bank of Minneapolis Quarterly Review, Summer 1999, v. 23, iss. 3, pp. 3-17

·* Conesa, J.-C., Krueger, D., and Kitao, S., 2008, “Taxing capital income: Not a bad idea after all!”, forthcoming, American Economic Review.

· Correia, Isabel, 1996, “Should capital income be taxed in the steady state?”, Journal of Public Economics, 60, pp 147-151

· Hassler, John, Per Krusell, Kjetil Storesletten and Fabrizio Zilibotti, “On Optimal Timing of Capital Taxation”, Journal of Monetary Economics, 55:4, May, 2008, pp. 692-709.