Optimal taxation under equilibrium unemployment and economic profits

Abstract

Abstract This paper develops a heterogeneous agent model with equilibrium unemployment and economic profits due to productive public investment. We find that the presence of profits plays an important role in the determination of long-run optimal tax policy. The Judd-Chamley optimal zero capital tax result can still hold in the model without profits. In this case, the optimal labour wedge is zero in the long run, resulting in welfare gains for all agents and no conflict of interests between agents. But the Benthamite government chooses to subsidise capital income in the long run in the model with economic profits. The resulting labour wedge is non-zero which generates welfare losses of workers despite welfare gains of capitalists. The government also faces a trade-off between efficiency and equity in this case.