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Endogenous income taxes in OLG economies

Zhang, Yan and Chen, Yan (2009): Endogenous income taxes in OLG economies.

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Abstract

This paper introduces fiscal increasing returns, through endogenous labor income tax rates as in Schmitt-Grohe and Uribe (1997), into the overlapping generations model with endogenous labor and consumption in both periods of life (for example, Cazzavillan and Pintus (2004)). We show that under numerical calibrations of the parameters, in particular a reasonable share of first period consumption over the wage income, local indeterminacy can easily occur with small distortionary taxes, provided that the elasticity of capital-labor substitution is less than the share of capital in total income and the wage elasticity of the labor supply is large enough. More important is the fact that increasing the size of tax distortions enlarges the range of values of the consumption--to--wage ratio associated with multiple equilibria, because of two conflicting effects on savings that operate through wage and interest rate.

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