In contrast to many other growth models we find that the taxation of human capital has a substantial negative effect on its accumulation; this in turn reduces innovation and, consequently, the income growth rate

Human capital, innovation, and growth. Clas Eriksson, Johan Lindén, Christos Papahristodoulou. International Journal of Economic Theory, May 16 2022. https://doi.org/10.1111/ijet.12346

Abstract: This paper explores the interaction between human capital and innovation in the process of economic growth. Using a model of endogenous growth, we focus on how taxes and other policy instruments affect the incentives to invest in human capital. In contrast to many other growth models we find that the taxation of human capital has a substantial negative effect on its accumulation. This in turn reduces innovation and, consequently, the income growth rate. More surprisingly, other policies that are intended to stimulate growth may have opposing effects on innovation and the accumulation of human capital. For example, while subsidies to research and to intermediate inputs do have positive effects on innovation and growth, they lead to a lower stock of human capital, in the empirically relevant case when the elasticity of intertemporal substitution in consumption is low.

6 CONCLUSIONS

Human capital and innovation are important drivers of economic growth. This paper explores a model in which both the acquirement of human capital and innovation are endogenous, and where a share of the human capital is used in research. We examine the incentives to undertake research and spend time in schooling, in particular with respect to the role of economic policy for those growth-promoting activities.

We develop a model similar to Romer (1990), with the important difference that human capital is endogenous. In addition, contrary to the simpler standard formulation in many other growth models where labor taxes drop out of the equations, our household's optimization implies that the taxation on human capital has a substantial negative effect on the formation of this factor. Since human capital is an essential input in research, this in turn lowers the income growth rate. Similarly, if the tax on unskilled labor is higher, more time will be spent in schooling to build human capital, resulting in a higher growth rate.

While subsidies to research and to intermediate inputs have positive effects on growth, they do not necessarily lead to a larger long-run stock of human capital in the economy. If the elasticity of intertemporal substitution in consumption is sufficiently low, these policy instruments stimulate growth by inducing a reallocation of a smaller stock of human capital toward more research.

An economy which taxes interest income at a higher rate will experience lower growth, because the representative household decides to shift some consumption from the future to the present in response to the lower net interest rate. The total stock of human capital is lower on the BGP and the relative wage increases.

Our model implies a substantial negative tax effect on economic growth. The analysis thus indicates that the design of the tax system may be important for the rate of growth in an economy. This theoretical finding is consistent with some important recent empirical research.