Abstract
We investigate the welfare effects of proportional income taxation 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 truthfully 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 substantially 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
Similar content being viewed by others
References
1. Balasko, Y., Cass, D. (1989): The structure of financial equilibrium with exogenous yields: the case of incomplete markets. Econometrica 57, 135–162
2. Cass, D., Citanna, A. (1998): Pareto improving financial innovation in incomplete markets. Economic Theory 11, 467–494
3. Citanna, A., Kajii, A., Villanacci, A. (1998): Constrained suboptimality in incomplete markets: a general approach and two applications. Economic Theory 11, 495–521
4. Citanna, A., Polemarchakis, H.M., Tirelli, M. (2001): The taxation of trades in assets. Working Paper No. 01-21. Department of Economics, Brown University, Providence, RI
5. De Marzo, P. (1988): An extension of the Modigliani–Miller theorem to stochastic economies with incomplete markets and independent securities. Journal of Economic Theory 45, 353–369
6. Diamond, P.A. (1967): The role of a stock market in a general equilibrium model with technological uncertainty. American Economic Review 57, 759–776
7. Diamond, P.A., Mirrlees, J.A. (1992): Optimal taxation of identical consumers when markets are incomplete. In: Dasgupta, P. et al. (eds.): Economic analysis of markets and games: essays in honor of Frank Hahn. MIT Press, Cambridge, MA, pp. 561–581
8. Dierker, E., Dierker, H., Grodal, B. (1999): Incomplete markets and the firm. Paper 9902. Department of Economics, University of Vienna, Vienna
9. Drèze, J.H. (1987): Investment under private ownership: optimality, equilibrium and stability. In: Drèze, J.H.: Essays on economic decisions under uncertainty. Cambridge University Press, Cambridge, pp. 261–297
10. Elul, R. (1995): Welfare effects of financial innovation in incomplete markets economies with several consumption goods. Journal of Economic Theory 65, 43–78
11. Elul, R. (1999): Welfare-improving financial innovation with a single good. Economic Theory 13, 25–40
12. Feldstein, M. (1976): On the theory of tax reform. Journal of Public Economics 6, 77–104
13. Geanakoplos, J., Magill, M., Quinzii, M., Drèze, J. (1990): Generic inefficiency of stock market equilibrium when markets are incomplete. Journal of Mathematical Economics 19, 113–151
14. Geanakoplos, J., Mas-Colell, A. (1989): Real indeterminacy with financial assets. Journal of Economic Theory 47, 22–38
15. Geanakoplos, J., Polemarchakis, H. (1986): Existence, regularity, and constrained suboptimality of competitive allocations when the asset market is incomplete. In: Heller, W.P., et al. (eds.): Uncertainty, information, and communication. Essays in honor of Kenneth J. Arrow. Vol. III. Cambridge University Press, Cambridge, pp. 65–95
16. Grossman, S.J., Hart, O.D. (1979): A theory of competitive equilibrium in stock market economies. Econometrica 47, 293–329
17. Guesnerie, R. (1977): On the direction of tax reforms. Journal of Public Economics 7, 179–202
18. Guillemin, V., Pollack, A. (1974): Differential topology. Prentice Hall, Englewood Cliffs, NJ
19. Hirsch, M.W. (1976): Differential topology. Springer, New York
20. Magill, M., Shafer, W. (1991): Incomplete markets. In: Hildenbrand, W., Sonnenschein, H. (eds.): Handbook of mathematical economics. Vol. IV. North-Holland, Amsterdam, pp. 1523–1614
21. Smale, S. (1974): Global analysis and economics. III. Pareto optima and price equilibria. Journal of Mathematical Economics 1, 107–117
22. Tinbergen, J. (1952): On the theory of economic policy. North-Holland, Amsterdam
23. Tirelli, M. (1999): Three essays on incomplete markets. Ph.D. dissertation. Columbia University, New York
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Tirelli, M. Income taxation when markets are incomplete. Decisions Econ Finan 26, 97–128 (2003). https://doi.org/10.1007/s10203-003-0038-6
Received:
Accepted:
Issue Date:
DOI: https://doi.org/10.1007/s10203-003-0038-6