Scandinavian Working Papers in Economics

Research Papers in Economics,
Stockholm University, Department of Economics

No 2007:2: Compositional and dynamic Laffer effects in models with constant returns to scale

Anders Fredriksson ()
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Anders Fredriksson: Institute for international economic studies, Postal: Stockholm University, S-106 91 Stockholm, Sweden

Abstract: There is a renewed interest in the dynamic effects of tax cuts on government revenue. The possibility of tax cuts paying for themselves over time definitely seems like an attractive option for policy makers. This paper looks at what conditions are required for reductions in capital taxes to be fully self-financing. This is done in a model with constant returns to scale in broad capital. Such a framework exhibits growth; the scope for self-financing tax cuts is therefore different than in the neoclassical growth model, most recently studied by Mankiw and Weinzierl (2006). Compared to previous literature, I make a methodological contribution in the definition of "Laffer effects" and clarify the role of compositional and dynamic effects in making tax cuts self-financing. I also provide simple analytical expressions for what tax rates are required for tax cuts to be fully self-financing. The results show that large distortions are required to get Laffer effects. Introducing a labor/leisure choice into the model opens up a new avenue for such effects, however.

Keywords: Human capital; compositional effects from taxation; dynamic effects from taxation; Laffer effect; dynamic scoring

JEL-codes: E62; H30; O41

34 pages, First version: February 23, 2007. Revised: April 21, 2004. Earlier revisions: April 21, 2007.

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