The Effects of Factor Taxation in Dynamic Economies with Externalities and Endogenous Labor Supply

Abstract

This chapter examines the long-run effects of factor income and expenditure taxes in an infinitely lived representative agent growth model that allows both for production externalities and endogenous labor supply. The novelty of this analysis is that it investigates how the long-run impacts of these taxes are affected by the indeterminacy of equilibria, mainly the result of nonseparable preferences between consumption and leisure. We show that the tax effects on steady-state welfare -as well as the steady-state levels of consumption, capital, and employment - are all negative, regardless of whether the steady state is determinate or indeterminate in the standard neoclassical growth model. When the model displays endogenous growth, the distortionary taxes are growth and welfare enhancing. This holds in both the determinate steady state, where the labor supply curve features an unconventional slope, and the indeterminate steady state, where it displays a conventional slope.