Risk Markups

We study optimal policy when heterogeneous markups reflect compensation for uninsurable persistent idiosyncratic risk. The optimal labor tax keep rate equals (1) the aggregate markup times (2) workers' consumption share divided by their Pareto weight. Markups correctly capture the private cost of risk that reduces labor demand, but they are socially inefficient. This requires a subsidy equal to the aggregate markup, as in the traditional market-power perspective. However, even with lump-sum transfers, risk markups lead entrepreneurs to dynamically overaccumulate wealth to self-insure, so impoverished workers oversupply labor. In the long run this effect dominates and it's optimal to tax labor.