Optimal Taxation and Income Mobility with Borrowing Limits

Abstract

The author studies age-dependent optimal taxation in an environment that takes into consideration changes in consumption behavior over the life cycle due to changes in labor income paths and borrowing limits. Income mobility is defined as an exogenous rate at which individuals change from a low-to a high-income path. In this framework, the role of age-dependent income taxation is reinforced. Consumption and leisure optimal allocations are not constant over the life cycle even when preferences are additively separable. As a result, age-dependent optimal capital income taxation faced by high-income earners differs from zero for all forms of preferences. In addition, past environments used to study optimal taxation appear as special cases of the proposed model. When the rate of income mobility is infinite, the proposed model nests the simple finite horizon framework. When life expectancy is infinite, the model nests the infinite horizon framework.