On Taxation in a Two-Sector Endogenous Growth Model with Endogenous Labor Supply

Abstract

This paper examines the effects of taxation on long-run growth in a two-sector endogenous growth model with (i) physical capital as an input in the education sector and (ii) leisure as an additional argument in the utility function. The analysis of the effects of taxation - including income taxation, capital income taxation and labor income taxation - distinguishes between the case with a unique (interior) balanced growth path and the case with multiple balanced growth paths. Due to the flexibility of labor supply, taxation of income may induce agents to spend more or less time on leisure activities. In the case of income taxation, where capital and labor income are taxed equally, the resulting effect on the growth rate is negative. The contribution of endogenous leisure is confined to reducing or increasing the size of the effect on the growth rate. If only capital income is taxed, the direction of the effect may reverse. In that case, the positive effect of the increase in total non-leisure time dominates the direct negative effect, implying that capital taxation increases the long-run growth rate.