Optimal Capital Taxation with Idiosyncratic Investment Risk

We examine the optimal taxation of capital in a Ramsey setting of a general-equilibrium heterogeneous-agent economy with uninsurable idiosyncratic investment or capital-income risk. We fully characterize the optimal tax in the case where there is no safe income in the economy. When the interest rate is allowed to adjust to changes in the capital tax, the optimal capital tax is always constant, even off steady state, and is positive when the variance of risk is higher than the mean return to the risky asset. When the interest rate is exogenously fixed, the optimal capital tax is zero. Therefore, general-equilibrium considerations are crucial for the dynamic effects of capital taxation when investment is risky.