Dynamic Laffer curves

Abstract

In an endogenous growth model with human capital accumulation, we discuss the possibility of welfare improving changes on the fiscal policy stance in some actual economies. First, we characterize the extent to which the initial fall in revenues produced by a permanent tax cut can be compensated by an increase in the tax base, due to a dynamic Laffer curve effect, showing that there is, in fact, a non-trivial margin for substituting debt for taxes on labor and capital income. Second, we show that the largest feasible reduction in labor income tax rates may easily produce a higher welfare gain than the largest feasible reduction in capital income tax rates. Two qualifications: (a) feasible tax cuts exist only for a relatively high elasticity of intertemporal substitution of consumption, and (b) the preference for the largest feasible tax cut on labor income rather than that on capital income reverses for a low appreciation for leisure, relative to consumption, in the preferences of the representative agent.