Income Taxation when Markets are Incomplete

Decisions in
Economics and
Finance

© Springer-Verlag 2003

Income taxation when markets are incomplete

Mario Tirelli

Department of Economics, Universita di Roma Tre
e-mail: [email protected]

Received: 19 October 2001 / Accepted: 19 December 2002 - © Springer-Verlag 2003

Abstract. We investigate the welfare effects of proportional income taxa-
tion in a standard general equilibrium model with incomplete markets (GEI).
Formally, our analysis is on the allocative effects of state-contingent income
tax reforms. Tax reforms are restricted to be anonymous, publicly and truth-
fully announced before markets open, and they are required to result in
an ex-post constrained efficient allocation. Our main result is to show that
there do typically exist contingent tax reforms that are Pareto improving.
These reforms, acting directly on the asset span, modify private risk-sharing
opportunities. Thus, unlike most of the GEI literature, the type of policy
transmission mechanism considered does not rely on second-order, relative
spot price effects. Yet, the key welfare effects of our tax reforms are substan-
tially equivalent to those induced through changes in relative spot prices, as,
for example, in Geanakoplos and Polemarchakis (1986), Geanakoplos et al.
(1990), or in Citanna et al. (2001).

Mathematics Subject Classification (2000): 58E17, 46N10, 93B29

Journal of Economic Literature Classification: D52, H21, H24, H25

I am particularly grateful to Paolo Siconolfi who advised me on earlier drafts of this paper.
I thank J. Dreze, M. Marchand, H. Polemarchakis, M. Wooders, and the participants of the
economic theory seminars at CORE, University of Pennsylvania, and Columbia University,
for comments. I also thank two anonymous referees of this journal for their very accurate
job. Remaining errors are my own. Financial support from the Franqui Foundation and the
European TMR program is gratefully acknowledged.

This version of the paper was prepared while I was a visiting professor at CORE-UCL.

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