Optimal tax mix in a two-sector growth model with transitional dynamics

This paper examines the problem of optimal tax mix analytically in a two-sector growth model with transitional dynamics. Tax revenue is required to provide a pure public good. The key problems are: over-consumption of leisure under labor income or consumption taxes; and under-investments in human and physical capital under income taxes. Without investment subsidies, consumption taxes do better than uniform income taxes, but can be improved on locally via positive taxation of physical capital income and a negative tax on labor income. With subsidies the first best can be achieved in a system where: (i) if consumption and labor income taxes are non-zero they are of the same rate but opposite signs, (ii) the tax rate on physical capital income exceeds that on labor income, (iii) subsidy rates on investments equal income tax rates, for both forms of capital. In any given circumstances, a range of alternative tax mixes may provide equivalent results. This result, combined with practical constraints, may help to explain the variety of tax mixes observed across countries.