Growth Effects of Income and Consumption Taxes

Abstract

The effects of income and consumption taxation are examined in the context of models in which the growth process is driven by the accumulation of human and physical capital. The different channels through which these taxes affect economic growth are discussed. It is shown that the effects of taxation on growth depend crucially on whether the sector producing human capital is a market sector, on the technology for human capital accumulation, and on the specification of the leisure activity. In general, the taxation of factor incomes (human and physical capital) is growth reducing, while the effects of a consumption tax depend on the specification of leisure. The paper also derives implications for the growth-maximizing choice of tax instruments. THE MERITS OF A SHIFT from current tax systems based on personal income taxation to one based on an expenditure tax are at the center of policy debates on tax reform in the United States and elsewhere. According to its proponents, an expenditure tax would eliminate the bias against savings inherent in a system based on income taxes, known as double taxation of savings. Eliminating this bias would encourage capital accumulation, thus raising future living standards. In this context, the relevant concept of capital includes both its physical and human components; therefore, a comparison of income and consumption taxes has to take into account their effects on the accumulation of both forms of capital. In this paper we explore the growth and welfare implications of income and consumption taxes in models where growth is endogenously determined by private agents' accumulation of physical and human capital. While the debate on the relative merits of consumption versus income taxation has a long intellectual history, which we briefly survey in section 1, this paper is more closely related to a number of recent theoretical contributions in the endogenous growth literature that have explored the effects of income and consumption taxes on economic growth. A seminal paper by Eaton (1981) showed that taxes can reduce growth in an endogenous growth setting. King and Rebelo (1990), Rebelo (1991),