Optimal taxation in dynamic economies with increasing returns

This paper studies optimal taxation in dynamic economies with increasing re turns. We show that if there exists a stable open-loop Stackelberg equilibr ium, the optimal rate of tax on capital income in the steady-state is negat ive in order to eliminate the wedge between the private and the social rate of return to capital. This result also holds when the government expenditu re has a positive effect on production activities of the private agents. In contrast, if the government takes a feedback strategy and if the governmen t budget is balanced in every period, then the optimal capital income taxat ion rule obtained under the open-loop strategy may be violated. It is, howe ver, shown that if the government can borrow from the public, the negative capital income tax rule may be established even under the feedback policy r ule. (C) 2001 Elsevier Science B.V. All rights reserved.