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How do productivity dynamics affect optimal taxation? This paper investigates this question theoretically and quantitatively by introducing Increasing Returns to Scale (IRS) and heterogeneous spending patterns (non-homothetic preferences) into the canonical tax problem of Mirrlees (1971). In this environment, any change in tax policy induces a change in labor supply, hence a change in market size, which translates endogenously into a change in productivity; this productivity response affects consumer prices and sets off another round of labor supply changes, market size changes, productivity changes, further labor supply changes, and so on. We show theoretically how to characterize these general equilibrium effects and we quantify their importance for the optimal tax schedule. The calibrated model matches empirical evidence on IRS as well as the tax schedule, earnings distribution and spending patterns observed in the United States. We establish three main results: (1) the optimal average tax rate is substantially lower on average, falling from about 45% under Constant Return to Scale (CRS) to about 35% with IRS (because IRS increase the efficiency cost of taxation); (2) with IRS and homothetic utility, optimal marginal tax rates are much less progressive than under CRS, and they become regressive above the 65th percentile of the income distribution (because IRS increase the efficiency cost of taxation relatively more for the rich); (3) with IRS and non-homothetic utility, optimal marginal tax rates become more progressive (intuitively, the planner internalizes that the productivity increase that could result from a tax break to the rich has low social value if the rich spend their marginal dollar on products that the poor do not consume much of). These findings indicate the importance of endogenous productivity and non-homotheticities for optimal taxation |
