Department of Economics University of Cyprus Are Nash Tax Rates Too Low or Too High? the Role of Endogenous Growth in Models with Public Goods

We reconsider the conventional wisdom that, in the presence of public goods, Nash tax rates are too low. We use a general equilibrium dynamic model of a world economy, in which world-wide environmental quality has public good features. We show that the type of the spillover effect from one country to another (and hence whether we under-tax, or over-tax, in a Nash equilibrium relative to a coordinated one) can be reversed when we introduce dynamics. Specifically, the spillover effect changes from positive (which is the static, traditional case) to negative once the same model allows for long-term endogenous growth. This happens because in a growing economy, long-run capital tax bases are elastic, so that a higher tax rate leads to lower economic growth, smaller tax bases, lower tax revenues, lower clean-up policy in each country, and this eventually implies a negative spillover effect upon other countries. Then, negative spillovers imply that long-run Nash tax rates on polluting firms’ output are too high.