Optimal tax policy in an endogenous growth model with a consumable service good

Abstract

The paper analyses the optimal tax policy in an endogenous growth model in a command economy, where the commodity output is produced with only physical capital, and skilled labour is the only input in producing the service good. In the benchmark model, per capita government expenditure is used to create human capital. Two cases are considered regarding taxation: in the first, tax is imposed on both commodity and service sectors, while in the second only the service sector is taxed. In each case the model derives the optimal tax rate and steady-state growth paths. In the first regime where both sectors are taxed we find the optimal tax rate on the service sector to be zero, but on commodity output it is positive. However, in the second regime there is also a unique optimal tax rate on the service sector to finance human capital accumulation. Comparing the growth rates in both cases we also observe that the imposition of tax on only the service sector instead of on both sectors yields a higher rate of growth if the population growth rate along with the marginal productivity of human capital is sufficiently high. We also show that when the service sector is taxed it may grow at a higher rate than the manufacturing sector. An extension of the benchmark model in which government spends tax revenue on accumulation of human capital as well as physical capital confirms that the optimal service tax rate is zero, but the optimal commodity tax rate is positive when both sectors are taxed.

Keywords

• taxation
• government policy
• endogenous growth
• command economy
• human capital accumulation