Minneapolis Fed, Report: A Ramsey Theory of Financial Distortions

“Within the context of a Ramsey model of capital taxation, we identified a force that operates as in Sargent and Wallace (1982) and pushes the government to increase its indebtedness to mitigate frictions in private asset markets. We showed that when it is impossible to completely undo those frictions in the long run, it is optimal to tax capital, even though its provision is already inefficiently low. This outcome happens because the frictions that prevent efficient investment also alter the elasticity of the supply of capital. In this case, a wedge between the returns on capital and bonds is also optimal. This paper considered an economy with no aggregate risk, in which no force countervails the upward drift in government debt. In a stochastic economy with non-contingent debt, Aiyagari et al. (2002) identify an opposite force, which induces the government to accumulate assets for self-insurance.”