Ramsey Asset Taxation with Asymmetric Information: Taxation of Asset Trades and Financial Market Structure

Abstract

Is there a role for the government in intervening by taxing trades in financial markets? If so, how does the intervention depend on the structure of the financial system? The structure of the financial system differs across countries: US and UK are market based, Japan and Continental Europe are intermediary based. Moreover, during recent years one of the most widespread phenomena is the development of financial markets. In this paper we study whether and how the taxation of trades in financial markets in the presence of agency frictions may allow to improve welfare. We consider an environment where consumers/entrepreneurs are subject to idiosyncratic shocks affecting their future income level. There are financial frictions since the realization of the shocks affecting the agents is affected by their effort level which is unobservable. Consumers/entrepreneurs can trade in competitive, anonymous markets for credit and insurance claims, where trades are non-observable (that is, there is non exclusivity in the contractual obligations achieved by trading in markets). The presence of moral hazard limits the viability of trades in financial assets. In addition, banks (or primary lenders) may also be present to provide credit and insurance: each agent can only trade a loan/insurance contract with a single primary lender (who operate then under a regime of exclusivity), but is then still free to complement it with trades in the financial market. In this environment the development of financial markets can be captured via a reduction in the severity of moral hazard that leads to stronger enforcement of contractual obligations, and can take the form both of wider types of contingent claims being traded and a larger role for primary lenders. We study optimal linear taxation of asset trades in this economy. Only allowing for linear and anonymous taxes or subsidies on trades is in line with the anonymity and unobservability of individual trades in financial markets. Both the optimal (`third best' or Ramsey) allocation and the nature of taxes depend on the structure of the financial system. In intermediary based systems taxes aim at reducing households’ trading possibilities in the asset markets (i.e., shutting down markets). In contrast, in `Market Based' financial systems taxes are designed to ease incentive compatible trading that would otherwise be prevented by moral hazard. We derive sharp (sufficient) conditions for positive or negative capital taxation showing that capital is taxed or subsidised depending on his complementarity with the acquisition of insurance (which is always taxed). (joint with Piero Gottardi, EUI)