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Taxation and Long-Run Growth

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A number of recent papers have investigated the growth effects of tax reforms in the context of neoclassical growth models where growth is due to human capital accumulation. Stokey and Rebelo (1995) show that the predicted growth effects disagree to a striking extent and are highly sensitive to the choices of several parameters about which little evidence exists. The purpose of this paper is to argue that the question should be reconsidered in the context of a life-cycle framework instead of the infinite horizon model used previously. Since human capital is not heritable, the infinite horizon case can no longer be derived as a reduced form of an altruistically linked dynasty of finitely lived individuals. Moreover, modeling agents as infinitely lived hides a fundamental asymmetry between human and physical capital: Since human capital cannot be sold or decumulated, agents must primarily use physical capital holdings to smooth consumption over the life-cycle and in particular to finance retirement consumption. As a consequence, changes in factor taxation mostly affect the stock of physical but not that of human capital. Correspondingly, our simulation results show that changes in flat rate factor taxation have little impact on long-run growth. In marked contrast to the previous literature, this result is remarkably robust to changes in the calibration and even to variations in the way human capital accumulation and intergenerational transfers are modeled. This strongly suggests that the large growth effects of taxation found previously overstate the true effect, perhaps by an order of magnitude. Much smaller effects are consistent with the observed stability of the U.S. growth trend in spite of dramatic increases in income tax rates after World War II.

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Paper provided by Arizona State University, Department of Economics in its series Working Papers with number 96/2.

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Handle: RePEc:wop:astewp:9602

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Keywords: Economic growth; taxation; human capital.;

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References

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  1. N. Gregory Mankiw, 1995. "The Growth of Nations," Harvard Institute of Economic Research Working Papers 1732, Harvard - Institute of Economic Research.
  2. King, R.G. & Rebelo, S.T., 1989. "Transitional Dynamics And Economic Growth In The Neoclassical Model," RCER Working Papers 206, University of Rochester - Center for Economic Research (RCER).
  3. Laurence J. Kotlikoff & Lawrence H. Summers, 1980. "The Role of Intergenerational Transfers in Aggregate Capital Accumulation," NBER Working Papers 0445, National Bureau of Economic Research, Inc.
  4. Robert G. King & Sergio Rebelo, 1990. "Public Policy and Economic Growth: Developing Neoclassical Implications," NBER Working Papers 3338, National Bureau of Economic Research, Inc.
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  9. Jones, Larry E & Manuelli, Rodolfo E & Rossi, Peter E, 1993. "Optimal Taxation in Models of Endogenous Growth," Journal of Political Economy, University of Chicago Press, vol. 101(3), pages 485-517, June.
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  17. Hanushek, Eric A, 1986. "The Economics of Schooling: Production and Efficiency in Public Schools," Journal of Economic Literature, American Economic Association, vol. 24(3), pages 1141-77, September.
  18. Nancy L. Stokey & Sergio Rebelo, 1993. "Growth Effects of Flat-Rate Taxes," NBER Working Papers 4426, National Bureau of Economic Research, Inc.
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  25. Glomm, Gerhard & Ravikumar, B, 1992. "Public versus Private Investment in Human Capital Endogenous Growth and Income Inequality," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 818-34, August.
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