On Taxation in a Two-Sector Endogenous Growth Model with Endogenous Labor Supply

Abstract

This paper studies the effects of taxation on long-run growth in a two-sector endogenous growth model with (i) physical capital as an input in the education sector and (ii) leisure as an additional argument in the utility function. Due to the flexibility of labor supply, taxation of income may induce agents to spend more or less time on leisure activities. Income taxation - the same rate applies for capital and labor income - reduces the growth rate. The contribution of endogenous leisure in this case is confined to reducing or increasing the size of the effect on the growth rate. The same is true if only labor income is taxed. However, if only capital income is taxed, the sign of the effect may reverse. In that case, the positive effect of the increase in total non-leisure time dominates the direct negative effect, implying that capital taxation increases the long-run growth rate.