Resource Misallocation and Aggregate Productivity under Progressive Taxation

This paper quantitatively examines the long-run macroeconomic effects of resource misallocation in an otherwise standard one-sector neoclassical growth model with heterogeneous firms being subject to progressive taxation as well as endogenous entry and exit decisions. Under a progressive fiscal policy rule, capital and labor inputs move from more productive firms to less productive establishments as the latter face a lower or negative tax rate. We find that since low-productivity firms use an inefficiently high level of productive resources when there are no entry and exit decisions, the overall production and aggregate productivity will fall as the tax progressivity rises. By contrast, more progressive taxation may raise the economy's total output and aggregate productivity when endogenous entry and exit decisions are allowed and the household's labor supply is postulated to be fixed. Our analysis therefore shows that the quantitative implications of progressive taxation are sensitive to the variability of hours worked and the presence of entry regulations.