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Taxation and Long-Run Growth

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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  1. King, Robert G & Rebelo, Sergio, 1990. "Public Policy and Economic Growth: Developing Neoclassical Implications," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages S126-50, October.
  2. James Davies & John Whalley, 1991. "Taxes and Capital Formation: How Important is Human Capital?," NBER Chapters, in: National Saving and Economic Performance, pages 163-200 National Bureau of Economic Research, Inc.
  3. Gregory Mankiw, 1995. "The Growth of Nations," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(1, 25th A), pages 275-326.
  4. Martin Feldstein & Andrew Samwick, 1992. "Social Security Rules and Marginal Tax Rates," NBER Working Papers 3962, National Bureau of Economic Research, Inc.
  5. 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).
  6. Lutz Hendricks, 2001. "Growth, Death, and Taxes," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(1), pages 26-57, January.
  7. 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.
  8. Kotlikoff, Laurence J & Summers, Lawrence H, 1981. "The Role of Intergenerational Transfers in Aggregate Capital Accumulation," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 706-32, August.
  9. Juster, F. Thomas & Stafford, Frank P., 1990. "The Allocation of Time: Empirical Findings, Behavioural Models, and Problems of Measurement," Working Paper Series 258, Research Institute of Industrial Economics.
  10. Eric M. Engen & Jonathan Skinner, 1996. "Taxation and Economic Growth," NBER Working Papers 5826, National Bureau of Economic Research, Inc.
  11. Salvador Ortigueira & Manuel S. Santos, 1994. "On Convergence in Endogenous Growth Models," Working Papers 9409, Centro de Investigacion Economica, ITAM.
  12. Hendricks, Lutz A., 1999. "Taxation and Long-Run Growth," Staff General Research Papers 11933, Iowa State University, Department of Economics.
  13. Lucas, Robert Jr., 1988. "On the mechanics of economic development," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 3-42, July.
  14. Welch, F, 1970. "Education in Production," Journal of Political Economy, University of Chicago Press, vol. 78(1), pages 35-59, Jan.-Feb..
  15. Nancy L. Stokey & Sergio Rebelo, 1993. "Growth Effects of Flat-Rate Taxes," NBER Working Papers 4426, National Bureau of Economic Research, Inc.
  16. Gary S. Becker & Nigel Tomes, . "Human Capital and the Rise and Fall of Families," University of Chicago - Population Research Center 84-10, Chicago - Population Research Center.
  17. Trostel, Philip A, 1993. "The Effect of Taxation on Human Capital," Journal of Political Economy, University of Chicago Press, vol. 101(2), pages 327-50, April.
  18. Duncan, Greg J & Hoffman, Saul, 1979. "On-the-Job Training and Earnings Differences by Race and Sex," The Review of Economics and Statistics, MIT Press, vol. 61(4), pages 594-603, November.
  19. Murphy, Kevin M & Welch, Finis, 1990. "Empirical Age-Earnings Profiles," Journal of Labor Economics, University of Chicago Press, vol. 8(2), pages 202-29, April.
  20. 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.
  21. Haley, William J, 1976. "Estimation of the Earnings Profile from Optimal Human Capital Accumulation," Econometrica, Econometric Society, vol. 44(6), pages 1223-38, November.
  22. 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.
  23. Poterba, James M., 1998. "The rate of return to corporate capital and factor shares: new estimates using revised national income accounts and capital stock data," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 48(1), pages 211-246, June.
  24. Heckman, James J, 1976. "A Life-Cycle Model of Earnings, Learning, and Consumption," Journal of Political Economy, University of Chicago Press, vol. 84(4), pages S11-44, August.
  25. Lucas, Robert E, Jr, 1990. "Supply-Side Economics: An Analytical Review," Oxford Economic Papers, Oxford University Press, vol. 42(2), pages 293-316, April.
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