Michigan
Retirement
Research
University of
Working Paper
WP 2004-066
Center
Trading with the Unborn: A New Perspective
on Capital Income Taxation
Kent A. Smetters
MR
RC
Project #: UM03-12
“Trading with the Unborn:
A New Perspective on Capital Income Taxation”
Kent A. Smetters
The Wharton School and NBER
March 2004
Michigan Retirement Research Center
University of Michigan
P.O. Box 1248
Ann Arbor, MI 48104
Acknowledgements
This work was supported by a grant from the Social Security Administration through the
Michigan Retirement Research Center (Grant # 10-P-98358-5). The opinions and
conclusions are solely those of the authors and should not be considered as representing
the opinions or policy of the Social Security Administration or any agency of the Federal
Government.
Regents of the University of Michigan
David A. Brandon, Ann Arbor; Laurence B. Deitch, Bingham Farms; Olivia P. Maynard, Goodrich;
Rebecca McGowan, Ann Arbor; Andrea Fischer Newman, Ann Arbor; Andrew C. Richner, Grosse Pointe
Park; S. Martin Taylor, Gross Pointe Farms; Katherine E. White, Ann Arbor; Mary Sue Coleman, ex
officio
Trading with the Unborn:
A New Perspective on Capital Income Taxation
Kent A. Smetters
Abstract
Security markets between generations are incomplete in the laissez-faire economy since
risk sharing agreements cannot be made with the unborn. But suppose that generations
could trade if, for example, a representative of the unborn negotiated on their behalf
today. What would the trades look like? Can government fiscal policy by used to
replicate these trades? Would completing this missing market be pareto improving when
the introduction of the new security changes the prices of existing assets?
This paper characterizes analytically the hypothetical trades between generations. It
shows how the government can replicate these trades by taxing the realized equity
premium on investments by either a positive amount or a negative amount. When
technology shocks are mostly driven by changes in depreciation, a positive tax on the
equity premium replicates the hypothetical trades; this tax is also driven by changes in
productivity, the choice between a positive and negative tax rate is unclear. However,
with log utility, Cobb-Douglas production, and a depreciation rate less than 100 percent,
the equity premium is to be taxed at a negative rate; this tax is also pareto improving.
Finally, simulation analysis is used to consider more complicated cases, including when
depreciation and productivity are both uncertain. Under the baseline calibration for the
U.S., a positive tax on the equity premium is pareto improving.
Authors’ Acknowledgements
Helpful comments were received from seminar participants at the 1998 Brown
Macroeconomics Workshop; the 1999 IMFseminar series; the 2000 Harvard Monetary
and Fiscal Policy Workshop; Centre for Economic Policy Research workshopheld in
Tilburg, Holland, 2000; 2000 Wharton Macro-Finance workshop, 2000 Wharton
Insurance and Risk ManagementWorkshop, as well as John Campbell, Laurence
Kotlikoff, Greg Mankiw, and Jan Walliser. This project was supportedwith a grant from
the Social Security Administration through the Michigan Retirement Research Center
(UM03-12).