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Does the progressivity of taxes matter for economic growth?

  • Elizabeth M. Caucutt
  • Selahattin Imrohoroglu
  • Krishna B. Kumar

A sizeable literature has argued that the growth effects of changes in flat rate taxes are small. In this paper, we investigate the relatively unexplored area of the growth effect of changes in the tax structure, in particular, in the progressivity of taxes. Considering such a tax reform seems empirically more relevant than considering changes in flat tax rates. We construct a general equilibrium model of endogenous growth in which there is heterogeneity in income and in the tax rates. We limit heterogeneity to two types, skilled and unskilled, and posit that the probability of staying or becoming skilled in the subsequent period depends positively on expenses on "teacher" time. In the production sector, we consider two sources of growth. In the first, growth arises as a purely external effect on account of production activities of skilled workers. In the second, a portion of the skilled workforce is used to work in research and other productivity enhancing activities and is compensated for it. Our analysis shows that changes in the progressivity of tax rates can have positive growth effects even in situations where changes in flat rate taxes have no effect. Experiments on a calibrated model indicate that the quantitative effects of moving to a flat rate system are economically significant. The assumption made about the engine of growth has an important effect on the impact of a change in progressivity. Quantitatively, welfare is unambiguously higher in a flat rate system when comparisons are made across balanced growth equilibria; however, when the costs of transition to the higher growth equilibrium is taken into account only the currently rich slightly prefer the flat rate system.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Discussion Paper / Institute for Empirical Macroeconomics with number 138.

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Date of creation: 2000
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Handle: RePEc:fip:fedmem:138
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  1. Romer, Paul M, 1986. "Increasing Returns and Long-run Growth," Journal of Political Economy, University of Chicago Press, vol. 94(5), pages 1002-37, October.
  2. Kahn, J. & Lim, J.S., 1997. "Skilled Labor-Augmenting Technical Progress in U.S. Manufacturing," RCER Working Papers 437, University of Rochester - Center for Economic Research (RCER).
  3. Asea, Patrick & Mendoza, Enrique G & Milesi-Ferretti, Gian Maria, 1996. "On the Ineffectiveness of Tax Policy in Altering Long- Run Growth: Harberger's Superneutrality Conjecture," CEPR Discussion Papers 1378, C.E.P.R. Discussion Papers.
  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.
  5. Peter Gottschalk & Robert Moffitt, 1994. "The Growth of Earnings Instability in the U.S. Labor Market," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 25(2), pages 217-272.
  6. Uhlig, Harald & Yanagawa, Noriyuki, 1996. "Increasing the capital income tax may lead to faster growth," European Economic Review, Elsevier, vol. 40(8), pages 1521-1540, November.
  7. Caucutt, Elizabeth M. & Kumar, Krishna B., 2003. "Higher education subsidies and heterogeneity: a dynamic analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 27(8), pages 1459-1502, June.
  8. Rogerson, Richard, 1988. "Indivisible labor, lotteries and equilibrium," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 3-16, January.
  9. David H. Autor & Lawrence F. Katz & Alan B. Krueger, 1998. "Computing Inequality: Have Computers Changed The Labor Market?," The Quarterly Journal of Economics, MIT Press, vol. 113(4), pages 1169-1213, November.
  10. Blankenau, William F. & Ingram, Beth F., 2002. "Welfare Implications Of Factor Taxation With Rising Wage Inequality," Macroeconomic Dynamics, Cambridge University Press, vol. 6(03), pages 408-428, June.
  11. Lucas, Robert E, Jr, 1990. "Supply-Side Economics: An Analytical Review," Oxford Economic Papers, Oxford University Press, vol. 42(2), pages 293-316, April.
  12. Nancy L. Stokey, 1990. "Human Capital, Product Quality, and Growth," Discussion Papers 883, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  13. Lucas, Robert Jr., 1988. "On the mechanics of economic development," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 3-42, July.
  14. Galor, Oded & Tsiddon, Daniel, 1997. "Technological Progress, Mobility, and Economic Growth," American Economic Review, American Economic Association, vol. 87(3), pages 363-82, June.
  15. Larry E. Jones & Rodolfo E. Manuelli, 1990. "Finite Lifetimes and Growth," NBER Working Papers 3469, National Bureau of Economic Research, Inc.
  16. Paul M Romer, 1999. "Endogenous Technological Change," Levine's Working Paper Archive 2135, David K. Levine.
  17. Eicher, Theo S, 1996. "Interaction between Endogenous Human Capital and Technological Change," Review of Economic Studies, Wiley Blackwell, vol. 63(1), pages 127-44, January.
  18. Kristin J. Forbes, 2000. "A Reassessment of the Relationship between Inequality and Growth," American Economic Review, American Economic Association, vol. 90(4), pages 869-887, September.
  19. Stokey, Nancy L & Rebelo, Sergio, 1995. "Growth Effects of Flat-Rate Taxes," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 519-50, June.
  20. Steven P. Cassou & Kevin J. Lansing, 1996. "Growth effects of a flat tax," Working Paper 9615, Federal Reserve Bank of Cleveland.
  21. Ayse Imrohoroglu & Selahattin Imrohoroglu & Douglas H. Joines, 1999. "Social Security in an Overlapping Generations Economy with Land," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(3), pages 638-665, July.
  22. 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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