Equilibrium efficiency in the Ramsey model with utility and production externalities

Purpose – The purpose of this paper is to analyze the effect of utility and production externalities on the equilibrium efficiency, and to devise tax policies capable of correcting the distortions caused by the external effects. Design/methodology/approach – The paper analyzes a Ramsey‐type model with utility and production externalities. It compares the decentralized equilibrium in the market economy with the optimal growth path attainable by a central planner. Findings – The paper shows the effects of utility and production externalities on competitive long‐run equilibrium values. It devises optimal tax policies capable of decentralizing the optimal growth path, and shows how the leisure specification affects the optimal tax policy. Practical implications – The paper adds to the literature on optimal taxation, and provides theoretical results that may help policy makers to set the tax policy. Originality/value – The paper analyzes the equilibrium efficiency in a rather general model with utility externalities, associated with both consumption and leisure, and production externalities. Equilibrium efficiency is studied under the two typical leisure specifications proposed in the literature: home production and raw time. This allows one to analyze the effect that the leisure specification has on the optimal tax policy.