Criticisms of endogenous growth models with flat rate taxes have highlighted two features that are not substantiated by the data. These models generally imply: (1) that economic growth must fall with the share of government expenditures in output across countries, and (2) that one-time shifts in marginal tax rates should instantaneously lead to similar shifts in output growth. In contrast, we show that allowing for heterogeneous households and progressive taxes into otherwise conventional linear growth models radically changes these predictions. In particular, economic growth does not have to fall, and may even increase, with the share of government expenditures in output across countries. Moreover, discrete permanent shifts in tax policy now lead to protracted transitions between balanced growth paths. Both of these findings hold whether or not government expenditures are thought to be productive and better conform to available empirical evidence.
The authors study the effects of progressive taxes in conventional endogenous growth models augmented to include heterogeneous households. In contrast to representative agent models with flat-rate taxes, this framework allows us to distinguish between marginal tax rates and the empirical proxies that are typically used for these rates such as the share of tax revenue, or government expenditures, in GDP. The analysis then illustrates how the endogenous nature of these proxy variables causes them to be weakly correlated, or even increase, with economic growth. This study, therefore, helps explain why cross-country regressions have mostly failed to uncover the distortional growth effects of taxes. In fact, while past U.S. tax reforms appear to have contributed only small increases in per capita GDP growth, the authors' analysis nevertheless suggests that differences in tax codes across countries explain a two and a half percent variation in cross-sectional growth rates. Finally, the authors show that progressivity also introduces significant lags in the effects of tax changes on output growth.
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