I study the optimal taxation of labor and capital in a dynamic economy subject to government expenditure and technology shocks. Unlike representative-agent Ramsey models, workers are heterogenous and lump-sum taxation is not ruled out. I consider two tax scenarios: (a) linear taxation, with a lump-sum intercept and (b) nonlinear-Mirrleesian taxation. When taxes are linear, I derive a partial-equivalence result with Ramsey settings that provides a reinterpretation of such analyses. I find conditions for perfect tax smoothing of labor-income taxes and zero capital taxation. Implications that contrast with Ramsey are derived for public-debt management, for the nature of the time-inconsistency problem and for the viability of replicating complete markets without state-contingent bonds. Shifts in the distribution of skills provide a novel source for variations in tax rates. For the nonlinear tax scenario, I show that taxation based on income averages is optimal. I.

This paper argues that a risk-averse worker's after-tax reservation wage encodes all the relevant information about her welfare. This insight leads to a novel test for the optimality of unemployment insurance based on the responsiveness of reservation wages to unemployment benefits. Some existing estimates imply significant gains to raising the current level of unemployment benefits in the United States but highlight the need for more research on the determinants of reservation wages. Our approach complements those based on Baily's [Journal of Public Economics, X (1978), 379–402] test.