Resource Misallocation and Aggregate Productivity under Progressive Taxation∗

This paper quantitatively examines the long-run macroeconomic effects of resource misallocation in an otherwise standard one-sector neoclassical growth model with heterogeneous establishments being subject to progressive taxation as well as endogenous entry decisions. Under a progressive fiscal policy rule, capital and labor inputs move from more productive to less productive establishments as the latter face a lower tax rate. We find that since low-productivity establishments use an inefficiently high level of productive resources when there are no entry decisions, the overall production and aggregate productivity will fall as the tax progressivity rises. By contrast, more progressive taxation may raise the economy’s total number of operating establishments as well as aggregate productivity when endogenous entry decisions are allowed. Our analysis therefore shows that the quantitative implications of progressive taxation are sensitive to the presence of entry regulations.