Optimal taxation and public production in an open dual economy

Abstract

This paper analyses the determinants of optimal tax policy, trade policy and shadow prices for cost-benefit analysis in a dual economy. It breaks new ground by combining in one model the tax and public investment policies considered in the public economics literature with the notion of labor market imperfection central to contributions on the dual economy. Optimal policies are first derived analytically, providing rules for organizing production, setting taxes and off-setting labor market distortions. Production efficiency is shown to obtain for the taxable part of the economy, a generalized Ramsey rule derived for producing-cumconsuming households in the directly non-taxable sector of the economy and new characterizations of optimal rural-urban migration established in the presence of distortionary taxation. A simple general equilibrium model is then numerically implemented on data for a particular developing country. The optimal policies analytically derived before are computed in the model under alternative assumptions about government revenue requirements, the degree to which different sectors of the economy are directly taxable, the nature of property rights and technological substitution possibilities. The results of these computations provide further insight into the theoretical results as well as clarifying their quantitative significance.