Lessons for Tax Reform from an Equilibrium Model of Innovation

Abstract

We formulate and estimate a general equilibrium model of innovation-led growth and use it to evaluate the quantitative implications of individual income tax reforms for innovation and aggregate productivity growth. In the model, innovation comes from entrants creating new products and incumbents improving own existing products. We estimate the model parameters by matching key moments of U.S. data. The model generates an aggregate labor supply elasticity and a per capita GDP growth response to marginal tax rate changes that are consistent with available empirical estimates. We find that the model accounts reasonably well for the observed movements in TFP, labor productivity, hours worked and number of firms per capita during the “Reagan tax cuts” of the eighties. The model predicts that a temporary, deficit-financed, 3 percentage points cut in the average marginal individual income tax rate, set to expire in 2025, produces a temporary TFP growth acceleration leading to a 6 percent increase in real per capita GDP by year 2040.

Keywords: Individual income tax; Economic growth; Total factor productivity; Firms’ entry; Innovation; R&D

JEL Classification: E23; E24; E62; O30; O40