Optimal Taxation and Indeterminacy in the Uzawa-Lucas Model with Sector-specific Externalities

Abstract

In an extended Uzawa-Lucas model that includes labor-leisure decisions, sector-speci c externalities in the production of goods generate a market failure relative to the socially optimal decisions. We show that, regardless of whether agents value pure or effective units of leisure, the first best solution can be attained either by using a time-varying subsidy to the human capital employed to produce goods or by combining consumption and labor income taxes with this type of subsidy. Moreover, when leisure is de ned as raw time, we fi nd that even when there is global determinacy, local indeterminacy may arise for several combinations of the parameters that are consistent with empirical evidence and previous literature. Importantly, under local indeterminacy the optimal policy does not ensure that identical economies will converge to the same per capita levels. Thus, not only the size and type of human capital externalities are important for optimal policy but also the indeterminacy aspects are relevant.