Heterogeneity and the Welfare Cost of Dynamic Factor Taxes

Zsolt Becsi
Federal Reserve Bank of Atlanta
Working Paper 99-2
March 1999

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The welfare costs of dynamic factor taxes are analyzed in a dynamic general equilibrium model with heterogeneous endowments, abilities, and tastes. Conventional functional form restrictions yield formulas for the transition effects and marginal welfare costs of factor taxes. Heterogeneity implies that taxes have feedback or distribution effects, beyond standard efficiency effects, that may lead to nonstandard aggregate dynamics. Also, marginal welfare costs vary systematically with initial distortions and agents' characteristics. Because factor taxes lower wealth inequality, equity gains offset efficiency losses with the offset weakening as initial distortions rise. However, distribution effects reinforce efficiency losses unless preexisting distortions are sufficiently high, in which case some types of heterogeneity yield offsetting distribution effects. Simulations suggest that, for labor taxes, distribution effects dominate dynamics, but not for capital taxes. Also, equity gains dominate efficiency losses and distribution effects for the marginal welfare cost of labor taxes, and vice versa for capital taxes.

JEL classification: D30, D6, H20, D90, D5

Key words: heterogeneity, welfare, factor taxation, dynamic general equilibrium

Much of this research is based on Becsi (1993), but insightful comments prompted significant extensions. The author is grateful to Robert Haveman, Martin David, and Peter Streufert for their support and invaluable suggestions. He also thanks Graziella Bertocchi, John Duca, Scott Freeman, Greg Huffman, Evan Koenig, Finn Kydland, Ed Prescott, Alan Stockman, Mark Wynne, Ping Wang, and seminar participants at the University of Texas, the University of Wisconsin, Pennsylvania State University, and Purdue University. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.

Please address questions regarding content to Zsolt Becsi, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/498-8785, 404/498-8058 (fax), zsolt.becsi@atl.frb.org.