Abstracts

In this paper we solve in closed form a general-equilibrium production-economy model in the spirit of the original Cox-Ingersoll-Ross production economy model from 1985 with a production technology that is stochastically homogeneous of degree one. Our model is a discrete time binomial model with perishable capital in the sense that households must decide every period how much to consume and how much to reinvest for future production and consumption. We add to this a redistributive tax system that makes richer households net contributors to poorer households in such a way that all tax revenues are returned to households in the aggregate; i.e., all consumption and reinvestment opportunities present in the economy without taxation and redistribution are also present in the economy after the introduction of taxation and redistribution.
Households are assumed to be identical in terms of preferences and have time-additive CRRA preferences. However, they diff er in terms of their endowment and, hence, in terms of their relative position in the wealth distribution. Consequently, they also di ffer in terms of the degree to which they are net recipients or net contributors to the transfer mechanism via the tax system.
Our results show that redistribution via a tax system can result in Pareto ine fficient aggregate production decisions and thus have negative aggregate welfare e ffects. This happens when taxation a ffects relative prices of present versus future con- sumption, which is the case, e.g., when households are taxed one a the basis of net earnings. In such a setting even households that are net recipients of transfers may be better o ff in the absence of a redistributive tax system: a smaller piece of a bigger cake may be preferable to a bigger piece of a smaller cake.
In the standard asset pricing and asset allocation model with a representative CRRA household, which implicitly assumes identical CRRA preferences across households, there are no bonds outstanding and no trading in fi nancial assets. When a redistributive tax system is introduced, households can only implement a Pareto optimal solution through dynamic trading in risky assets as well as in riskless bonds.