Growth Effects of Income and Consumption Taxes

By Milesi-Ferretti, Gian Maria | Journal of Money, Credit & Banking, November 1998 | Go to article overview

Growth Effects of Income and Consumption Taxes


Milesi-Ferretti, Gian Maria, Journal of Money, Credit & Banking


The effects of income and consumption taxation are examined in the context of models in which the growth process is driven by the accumulation of human and physical capital. The different channels through which these taxes affect economic growth are discussed. It is shown that the effects of taxation on growth depend crucially on whether the sector producing human capital is a market sector, on the technology for human capital accumulation, and on the specification of the leisure activity. In general, the taxation of factor incomes (human and physical capitol) is growth reducing, while the effects of a consumption tax depend on the specification of leisure. The paper also derives implications for the growth-maximizing choice of tax instruments.

The merits of a shift from current tax systems based on personal income taxation to one based on an expenditure tax are at the center of policy debates on tax reform in the United States and elsewhere. According to its proponents, an expenditure tax would eliminate the bias against savings inherent in a system based on income taxes, known as "double taxation of savings." Eliminating this bias would encourage capital accumulation, thus raising future living standards. In this context, the relevant concept of capital includes both its physical and human components; therefore, a comparison of income and consumption taxes has to take into account their effects on the accumulation of both forms of capital. In this paper we explore the growth and welfare implications of income and consumption taxes in models where growth is endogenously determined by private agents' accumulation of physical and human capital.

While the debate on the relative merits of consumption versus income taxation has a long intellectual history, which we briefly survey in section 1, this paper is more closely related to a number of recent theoretical contributions in the endogenous growth literature that have explored the effects of income and consumption taxes on economic growth. A seminal paper by Eaton (1981) showed that taxes can reduce growth in an endogenous growth setting. King and Rebelo (1990), Rebelo (1991), Pecorino (1993), Devereux and Love (1994), and Stokey and Rebelo (1995) present analytical and calibration results showing that income taxes are in general growth reducing, while the growth effects of consumption taxes depend on model specification.(1)

This paper generalizes the results of previous contributions and presents some new results in the context of a unified analytical framework. By explicitly discussing the channels through which labor income, capital income, and consumption taxes affect resource allocation and growth, it shows how the effects of taxation depend crucially on (i) the specification of leisure, (ii) the structure of the human capital accumulation sector, and (iii) its tax treatment. With regard to the first point, the paper considers different formulations of the leisure activity, such as raw time, quality time, and home production. With regard to the second, it examines the case in which the production of human capital requires only human capital and hours and the case in which it requires physical capital inputs as well. With regard to the third, it explores the implications of considering the production of human capital (education) as a nonmarket or a market activity, and the effects of a subsidy to human capital accumulation in the latter case. Finally, it discusses growth-maximizing tax policy when the government has to run a balanced budget.

The structure of the paper is as follows. Section I presents a survey of the debate on the relative merits of consumption versus capital and labor income taxation. Section 2 presents the model, and section 3 solves for the competitive equilibrium. The positive analysis of the effects of different taxes on the growth rate of the economy is presented in section 4; section 5 studies the growth-maximizing tax structure. …

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