The Effects of Financial Frictions on Optimal Corporate Income and Consumption Taxation in an R&D-Driven Growth Model

Does reducing the corporate income tax while increasing the consumption tax to satisfy government budget constraints improve welfare? To address this question, this paper examines the welfare-maximizing consumption and corporate income tax rates within a Rivera-Batiz and Romer (1991)-type variety-expanding growth model with financial frictions and heterogeneous R&D productivity. We also explore how these welfare-maximizing tax rates change as financial constraints become less binding due to financial development. The results indicate that under mild and plausible levels of financial frictions, relaxing financial constraints on R&D investment lowers the optimal corporate income tax rate, while raising the optimal consumption tax rate. This finding implies that when financial constraints are eased, enhancing innovation at the expense of current production-by raising the consumption tax and reducing the corporate income tax-improves welfare. The underlying mechanism is that relaxing financial constraints induces entry into R&D only by highly productive entrepreneurs, thereby increasing the average efficiency of R&D investment.