Resource misallocation and aggregate productivity under progressive taxation

This paper quantitatively examines the long-run macroeconomic effects of resource misallocation in an otherwise standard one-sector neoclassical growth model with heterogeneous establishments, characterized by different ages and productivity levels, that are subject to progressive taxation as well as endogenous entry decisions. Under a progressive fiscal policy rule, capital and labor inputs move from more productive to less productive establishments because the latter face a lower tax rate. When the tax progressivity rises, the economy’s overall production will fall since low-productivity establishments use an inefficiently high level of productive resources (the intensive margin). On the other hand, more progressive taxation reduces the economy’s total number of operating establishments, which in turn further decreases aggregate output (the extensive margin). Under our benchmark parameterization to match with the U.S. data, we find that the measured aggregate productivity also falls when the tax schedule becomes more progressive. For the sensitivity analyses, we consider alternative specifications with fixed labor supply or different returns-to-scale in production; and undertake a counterfactual cross-country comparison with China and India.