Optimal Taxation and Public Good Provision with Heterogeneous Risk Preferences

This paper investigates the optimal taxation of risky and safe capital income when heterogeneous returns are driven by heterogeneous risk preferences, and (risky) tax revenues finance a (risky) public good that provides insurance against aggregate risk. Agents make intertemporal consumption and portfolio decisions over a two-period horizon, choosing between two types of assets: one riskless, and one being subject to aggregate risk. The main theoretical result is that the optimal variance of the public good is set by the excess return tax to balance different agents’ “demands” for insurance. Moreover, a trade-off between insurance and intertemporal efficiency can arise, and taxing the safe return can be optimal. Numerical simulations show that the (risky) public good has a lower expected value and variance if the government gives more weight to the most risk averse agents: safer individual prospects must match with a safer public policy.