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

Abstract

The paper analyses the op-timal 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 govern-ment 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 sec-tor 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 capi-tal 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 manu-facturing sector. An extension of the bench-mark 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.