Working Paper: NBER ID: w25783
Authors: Beenlon Chen; Hungju Chen; Ping Wang
Abstract: In a second-best optimal growth setup with only factor taxes, it is in general optimal to fully replace capital by labor income taxation in the long run. We revisit this important issue by developing a human capital-based endogenous growth model with frictional labor search, allowing each firm to create multiple vacancies and each worker to determine market participation. We find that the conventional efficient bargaining condition is necessary but not sufficient for achieving constrained social optimality. We then conduct tax incidence exercises in balanced growth by calibrating to the U.S. economy with a pre-existing 20% flat tax on capital and labor income. Our quantitative results suggest that, due to a dominant channel via the interactions between vacancy creation and market participation, it is optimal to switch only partially from capital to labor taxation in a benchmark economy where human capital formation depends on both physical and human capital stocks. This main finding is robust even along the transition with time-varying factor tax rates. Moreover, our quantitative analysis under alternative setups suggest that while endogenous human capital and labor market frictions are essential for obtaining a positive optimal capital tax, endogenous leisure, nonlinear human capital accumulation and endogenous growth are not crucial.
Keywords: Tax Incidence; Human Capital; Endogenous Growth; Labor Market Frictions
JEL Codes: E62; H22; J24; O41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital taxation (H24) | bargained wage rate (J52) |
| labor taxation (J89) | bargained wage rate (J52) |
| increase in capital tax rate (F38) | wage discount (J31) |
| wage discount (J31) | vacancy creation (J63) |
| vacancy creation (J63) | job finding rate (J68) |
| job finding rate (J68) | labor market participation (J29) |
| labor market participation (J29) | employment (J68) |
| employment (J68) | output growth (O40) |
| capital tax rate (H32) | social welfare (I38) |
| labor market frictions (J29) | optimal tax rates (H21) |
| human capital accumulation (J24) | optimal tax rates (H21) |
| capital taxation (H24) | labor taxation (J89) |