DEPARTMENT OF ECONOMICS UNIVERSITY OF CYPRUS NASH TAX RATES AND PUBLIC GOOD PROVISION: Revisiting free riding in a growing economy

This short paper provides an example which shows that the type of the spillover effect from one individual to another (and hence whether we under-tax, or overtax, in a Nash equilibrium relative to a cooperative one) can be reversed when we introduce dynamics into a model with public goods. 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. Therefore, free riding is associated with too low Nash tax rates in a static economy, but with too high Nash tax rates in a growing economy. This is because, in a growing economy, free-riding and small tax contributions are achieved by relatively high tax rates, low growth and small tax bases. By contrast, in a static set-up where tax bases are exogenously given, free-riding and small tax contributions are typically achieved by relatively low tax rates.