Welfare-improving Consumption Tax in the Presence of a Wage Tax under Idiosyncratic Returns from Investment and Incomplete Markets

In a standard multiperiod model, consumption tax and wage tax are equivalent. I show that when a capital market is incomplete – in the sense that the rates of return from risky investments are idiosyncratic and there is no insurance for such idiosyncratic risk – the introduction of a consumption tax in the presence of a wage tax improves welfare. This holds true even in the presence of optimal or nonoptimal capital income taxes. In the general-equilibrium model, the optimal level of the consumption tax is determined to balance the benefits of the risk-sharing effect and the asset accumulation effect against the costs of postponing government revenue to later periods.