This article studies optimal Ramsey taxation when risk sharing in private insurance markets is imperfect due to limited enforcement. In a limited commitment economy, there are externalities associated with capital and labour because individuals do not take into account that their labour and saving decisions affect aggregate labour and capital supply and wages, and thus the value of autarky. Therefore, a Ramsey government has an additional goal, which is to internalize these externalities of labour and capital to improve risk sharing, in addition to its usual goal—minimizing distortions in financing government expenditures. These two goals drive capital and labour taxes in opposite directions. It is shown that the steady-state optimal capital income taxes are levied only to remove the negative externality of the capital, whereas optimal labour income taxes are set to meet the budgetary needs of the government in the long run, despite the presence of positive externalities of labour.

We derive a fully non-linear optimal income tax schedule in the presence of private insurance. We fill the gap in the literature by studying the optimal tax formula with a comprehensive structure of the private markets—including incomplete markets models—both theoretically and quantitatively. As in the standard taxation literature without private insurance, the optimal tax formula can still be expressed in terms of standard sufficient statistics. With private insurance, however, the formula involves additional terms that reflect how the private market interacts with public insurance. For example, the optimal tax formula should also consider asset distribution and pecuniary externalities as well as the welfare effects of borrowing constraints.

We analyse efficient risk-sharing arrangements when the value from deviating is determined endogenously by another risk-sharing arrangement. Coalitions form to insure against idiosyncratic income risk. Self-enforcing contracts for both the original coalition and any coalition formed (joined) after deviations rely on a belief in future cooperation which we term “trust”. We treat the contracting conditions of original and deviation coalitions symmetrically and show that higher trust tightens incentive constraints since it facilitates the formation of deviating coalitions. As a consequence, although trust facilitates the initial formation of coalitions, the extent of risk sharing in successfully formed coalitions is declining in the extent of trust and efficient allocations might feature resource burning or utility burning: trust is indeed a double-edged sword.