Political Economy of Intermediate Goods Taxation

We generalize the Diamond-Mirrlees production efficiency theorem, that there should be no taxes on sectors producing pure intermediate goods, to an environment with political economy constraints. In our economy, allocations and taxation are decided by self-interested politicians without the power to commit to future policies. The Diamond-Mirrlees production efficiency result holds even when political economy constraints introduce distortions on labor supply and capital accumulation. (JEL: H11, H21, E61, P16) (c) 2008 by the European Economic Association.