Optimal Taxes and Transfers with Household Heterogeneity

We investigate the properties of optimal fiscal policy in a framework where household heterogeneity is accounted for. The Ramsey planner chooses (distortionary) labor taxes and transfers to maximize aggregate welfare in a two-agent economy. We contrast the properties of optimal labor taxes in our model to the ones obtained in the representative agent counter-part. We first show that the presence of household heterogeneity introduces an additional source of fluctuations in the optimal tax rate, as varying taxes allows the planner to use transfers for redistributive purposes. We then show that, depending on the assumptions that are made on how transfer receipts are distributed among households, and the type of shocks hitting the economy, the structure of government bond markets becomes more or less important in shaping the dynamics of the Ramsey allocation. In some cases, the presence of transfers brings the incomplete markets allocation close to the one in which the planner has access to state-contingent claims. We finally show that the presence of heterogeneity and optimal transfers helps bring the behaviour of fiscal variables in the Ramsey model closer to their counterpart in US data.