Taxation and Endogenous Growth in Open Economies

IMF Working Papers, July 1, 1994

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This paper examines the effects of taxation of human capital, physical capital and foreign assets in a multi-sector model of endogenous growth.
It is shown that in general the growth rate is reduced by taxes on capital and labor (human capital) income.
When the government faces no borrowing constraints and is able to commit to a given set of present and future taxes, it is shown that the optimal tax plan involves high taxation of both capital and labor in the short run. This allows the government to accumulate sufficient assets to finance spending without any recourse to distortionary taxation in the long run.
When restrictions to government borrowing and lending are imposed, the model implies that human and physical capital should be taxed similarly.

Taxes on capital and labor (human capital) income reduce the growth rate.
With no government borrowing constraints and commitment to a tax path:
- Optimal policy features high short-run taxes on both capital and labor.
- High short-run taxation enables accumulation of government assets to finance future spending without distortionary taxation in the long run.
With restrictions on government borrowing and lending:
- The model implies similar taxation of human and physical capital.

Consider permitting government commitment to present and future taxes to enable an optimal tax plan that uses short-run taxation to build government assets.
Where government borrowing and lending are constrained, tax policy should treat human and physical capital similarly.