Growth Effects of Taxation Under Altruism and Low Elasticity of Intertemporal Substitution

Abstract

An increase in the tax rate on capital income may raise the rate of economic growth when the elasticity of intertemporal substitution is low and intergenerational transfers are absent. Since the strength of the bequest motive depends on tax rates, this paper provides conditions under which taxing capital income, and then reducing the labour income tax, is more growth enhancing than the classical policy of zero taxes on capital income, and vice versa. This paper analyses the effects of different taxes on the rate of economic growth. We consider an economy in which public spending is a fixed fraction of the GNP and the government can obtain revenues from proportional taxes on both labour and capital income. Obviously, the growth effects of these two instruments will depend on the assumptions made about the economic environment. In the standard overlapping generations (OLG) model with production (Diamond, 1965), an increase in capital income taxes allows a reduction in labour income taxes, and thus agents will enjoy more income when they are young. Since in the OLG model young agents must purchase the total stock of capital installed in the next period, and saving is increasing in young income, higher taxes on capital income may lead to faster capital accumulation. In order to complete the argument, we must ensure that the associated decrease in the after-tax interest rate does not lead to a reduction in saving which would outweigh the previous income effect. In other words, we need a sufficiently low elasticity of intertemporal substitution. The argument is thus similar to the one of Jones and Manuelli (1992), who have already pointed out that, if the technological environment makes sustained growth feasible, then taxing the old agents and subsidising the young ones may increase the rate of economic growth. However, the situation is completely different if we consider instead an economic environment in which the life-cycle considerations are absent. For instance, in endogenous growth models with a representative agent (or dynasty) and infinite life-span, an increase in the capital income tax rate typically translates into lower growth (see, for instance, Sato, 1967; Feldstein, 1974; Stiglitz, 1978; and the more recent contributions of Lucas, 1990; and Rebelo, 1991). A way to give a unified treatment to these two alternative models is by means