Public investment, factor income taxation, and intergenerational welfare distribution in an overlapping generations model

Abstract

This paper examines intergenerational welfare effects of public investment financed by factor income taxes in a perpetual-youth overlapping generations model. With elastic labor supply, our analysis shows that long-run employment increases as the tax rate on capital income increases. The positive long-run effect of capital income taxation on employment weakens the negative growth effect of tax distortion. In contrast, the long-run employment might decrease as the tax rate on labor income increases. Hence, the negative long-run effect of labor income taxation on employment strengthens the negative growth effect due to the tax distortion. Finally, this paper reveals that older people with more financial wealth suffer more significant welfare loss from the increased tax on each capital and labor income than younger people if the increased tax impedes economic growth. Furthermore, the increased tax harms the younger generations more than the older generations at the aggregate level because they have a larger population than the older people. However, the negative welfare effects of labor income taxation are stronger than those of capital income taxation because of the negative effect of labor income taxation on employment, which leads to a lower equilibrium growth rate.