School of Economics

Tax smoothing in a business cycle model with capital-skill complementarity

Konstantinos Angelopoulos, Stylianos Asimakopoulos and James Malley

This paper contributes to the tax smoothing literature by focusing on the differences in the complementarity between capital and skilled/unskilled labour as well as the endogenous determination of the relative skill supply for Ramsey tax policy. The aim of the paper is to undertake a normative investigation of the quantitative properties of optimal taxation of capital and labour income, as well as skill-acquisition expenditure, in the presence of aggregate shocks to total factor productivity, investment-specific technological change and government spending. There are complete asset markets, but the implications of different assumptions regarding the mechanism driving skill acquisition, which can lead to labour market imperfections, are considered. First, the paper evaluates the effects of externalities in skill creation given the relevance of peer effects related to neighbourhood and social class. Second, the importance of shocks to exogenous non-fiscal policy interventions and socio-political factors affecting skill formation are considered. Finally, the implications of restricting the ratio of skilled to total workers to remain constant are examined.

This paper, published in Journal of Economic Dynamics and Control, develops a model that extends the complete markets neoclassical setup in Zhu (1992) and Chari et al. (1994) by allowing for a division of the labour force into skilled and unskilled workers, an endogenous skill supply and externalities in skill-acquisition on the household side, and capital-skill complementarity on the goods production side. This setup implies a wage premium for skilled labour, the relative supply of which can be increased by a cost to the household in the form of earmarked training expenditure. As in Chari et al. (1994) households save in the form of physical capital and state-contingent government bonds. The household is modelled as an infinitely-lived representative dynasty. The head of the household makes all choices on behalf of its members by maximising the aggregate welfare of the family, ensuring that each household member experiences the same level of consumption irrespective of individual labour market status. Firms use capital, skilled and unskilled labour to produce a homogeneous product. Following Katz and Murphy (1992), Krusell et al. (2000) and Hornstein et al. (2005), skilled labour is assumed to be more complementary to capital than unskilled labour. Hence, capital accumulation as well as technological developments and government policies that are capital augmenting, tend to increase the skilled wage premium. In contrast, increases in the relative supply of skilled labour act to reduce the skill premium. Finally, the government can borrow and tax capital, skilled and unskilled labour income separately, to finance subsidies on skill-acquisition expenditure and exogenous public spending. The paper finds that skilled and unskilled labour tax smoothing maintain quantitatively under externalities and exogenous shocks in skill acquisition, as well as when the relative skill supply is exogenously determined. It is further found that the government finds it optimal to reduce both the size of the wedge between the marginal rates of substitution and transformation in skill attainment in the long-run and the standard deviation of this wedge over the business cycle. This is achieved by subsidising skill creation and taxing both types of labour income.

Journal of Economic Dynamics and Control, “Tax smoothing in a business cycle model with capital-skill complementarity” by Konstantinos Angelopoulos, Stylianos Asimakopoulos and James Malley.


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Posted on Wednesday 22nd July 2015

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