Tax Reform with Endogenous Borrowing Limits and Incomplete Asset Markets

This paper studies different income tax reforms in an infinite horizon economy with a progressive labor income tax code, incomplete markets an endogenous borrowing constraints on capital holdings. In particular, it assumes that households can break their trading arrangements by going into financial autarky, in which case they are excluded from future asset trade. The endogenous limits are then determined at the level at which households are indifferent between defaulting and paying back their debt. These limits are significantly different from zero and they get looser with a higher labor income, a property that is consistent with US data on credit limits. The reforms we study area all revenue neutral and they eliminate capital income taxes but they differ in the changes to the labor income tax code. Our results illustrate that a successful reform has to combine the increase in average labor taxes with an increase in the progressivity of the labor income tax code. On the one hand, this reduces the disposable income of the rich, leading to lower savings and to a lower aggregate capital. On the other hand, it allows the poor and middle income households to supply less labor and consume and more after the reform, increasing the aggregate welfare both in the long run an throughout the transition.