OPTIMAL CAPITAL INCOME TAXATION WITH INCOMPLETE MARKETS, BORROWING CONSTRAINTS, AND CONSTANT DISCOUNTING

For a wide class of infinitely lived agent models, Chamley has shown t hat the optimal capital income tax rate is zero in the long run. Lucas has argued that for the U.S. economy, there is a significant welfare gain from switching to this policy. This paper shows that for the Bewl ey class of models with incomplete insurance markets and borrowing con straints, the optimal tax rate on capital income is positive, even in the long run. Therefore, cutting the capital income tax to zero may we ll lead to welfare losses.