Fiscal sustainability and market incompleteness: quantitative findings for Japan

This paper performs the fiscal sustainability exercise of Hansen and İmrohoroğlu (Rev Econ Dyn 21: 201–224, 2016) in the Aiyagari (Q J Econ 109: 659–684, 1994) incomplete markets (IM) framework. The focus is on characterizing stationary equilibrium allocations in the model as well as its certainty-equivalent counterpart representing complete markets (CM). Both models are calibrated to the same data moments. We quantify the role of market structure, labor supply elasticity, the coefficient of relative risk aversion, and the specific fiscal tool used in achieving fiscal sustainability. We find that both the complete markets and incomplete-markets models require quantitatively similar increases in the tax rate. The difference in the effects on equilibrium allocations across different market structures is larger. In addition, labor supply elasticity matters for allocations but not much for the needed increase in the tax rate. Using the consumption tax or the labor income tax matters for equilibrium allocations but not so much for the increase in the needed tax rate. Finally, it is not feasible to achieve fiscal sustainability by using only the capital income tax.