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Optimal Factor Tax Incidence in Two-sector Human Capital-based Models

This paper studies the optimal factor tax incidence in a standard two-sector, human capital-based endogenous growth model elucidated by Lucas (1988). Capital income taxes generate dynamic inefficiency for capital accumulation and labor income taxes create dynamic inefficiency for human capital accumulation. A factor tax incidence is a tradeoff between these two inefficiencies. A switch from capital income taxes to labor income taxes reduces the long-run welfare coming from lower leisure and increases the long-run welfare originated from higher economic growth and higher consumption. Because the representative agent’s learning time and human capital are inseparable and thus affect learning activities at the same degree, we find that based on the current US income tax code, it is optimal to first tax capital income, and to resort to taxing labor income only when tax revenue is insufficient to cover government expenditure.

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Paper provided by Institute of Economics, Academia Sinica, Taipei, Taiwan in its series IEAS Working Paper : academic research with number 12-A018.

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Length: 49 pages
Date of creation: Dec 2012
Date of revision:
Handle: RePEc:sin:wpaper:12-a018
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