Taxation and Endogenous Growth in Open Economies


WP/94/77-EA
Taxation and Endogenous Growth in Open Economies by Gian Maria Milesi-
Ferretti and Nouriel Roubini


This paper reconsiders the issue of the optimal taxation of human
capital, physical capital and foreign assets in the context of models of
endogenous growth. In a neoclassical exogenous growth framework, the
standard result (the Chamley-Judd proposition) is that in the long run
the optimal tax rate on physical capital income should be zero. In the
long run, revenues should be collected only through taxes on labor income
(wage taxes) since this is the way to tax the factor in fixed supply
(the labor/leisure time endowment).

The presence of human capital modifies significantly these results.
This happens because labor becomes a reproducible factor (human capital)
and, therefore, a source of accumulation and growth in addition to physical
capital. This paper studies how the impact on growth of human and physical
capital income taxation and of taxation of foreign assets depends on the
technologies for human capital accumulation and leisure. The normative
implications of the model for the optimal taxation of factor incomes are
also derived.

The paper shows that there are general specifications under which the
optimal long-run tax on both capital and labor income is zero. In these
cases, the optimal taxation plan consists of taxing both factors in the
short run, and financing spending in the long run through accumulated budget
surpluses. Such a solution presupposes the ability of the government to
commit to a given path of taxation into the foreseeable future. If
restrictions on the ability of the government to borrow and lend are
imposed, in the form of a balanced-budget constraint, the model implies
that human and physical capital should be taxed similarly.