Rising markups and optimal redistributive taxation

International Tax and Public Finance https://doi.org/10.1007/s10797-021-09712-y Rising markups and optimal redistributive taxation Eren Gürer1 Accepted: 23 October 2021 © The Author(s) 2021 Abstract This study explores the implications of rising markups for optimal Mirrleesian income and profit taxation. Using a stylized model with two individuals, the main forces shaping welfare-optimal policies are analytically characterized. Although a higher profit tax has redistributive benefits, it adversely affects market competition, leading to a greater equilibrium cost-of-living. Rising markups directly contribute to a decline in optimal marginal taxes on labor income. The optimal policy response to higher markups includes increasingly relying on the profit tax to fund redistribution. Declining optimal marginal income taxes assists the redistributive function of the profit tax by contributing to the expansion of the profit tax base. This response alone considerably increases the equilibrium cost-of-living. Nevertheless, a majority of the individuals become better off with the optimal policy. If it is not possible to tax profits optimally, due, for example, to profit shifting, increasing redistribution via income taxes is not optimal; every individual is worse off relative to the scenario with optimal profit taxation. Keywords Markups · Optimal redistribution · Imperfect competition · Taxation JEL Classification D43 · H21 · H25 I am grateful to Alfons J. Weichenrieder for his guidance and continuous support. I would also like to thank Ariana Gilbert-Mongelli, Alexander Ludwig, Besart Avdiu, Danny Yagan, Emmanuel Saez, Florian Scheuer, Georg Dürnecker, Hakki Yazici, Jan Eeckhout, Jonas Loebbing, Onursal Bagirgan, Osman Kücüksen, Selen Yildirim, participants of the Spring 2020 Visitors Workshop at UC Berkeley IRLE, seminar participants at Goethe University Frankfurt, Marmara University, Ozyegin University, TED University, Catholic University of Milan, Stavanger Business School, Umeå University, Middle East Technical University, participants of 8th Mannheim Tax Conference for providing valuable comments and discussions. * Eren Gürer 1 Goethe University, Frankfurt, Germany 13 Vol.:(0123456789) E. Gürer 1 Introduction A lack of competitive pressure allows firms to set prices higher than marginal costs. Recent empirical studies report that markups, the wedge between marginal costs and prices, are on the rise in many countries across the globe (Loecker and Eeckhout 2018), including the USA (Loecker et al. 2020; Hall 2018). As a result, the welfare of the individuals, whose wages are a part of marginal costs, declines due to a higher cost-of-living. Because of declining marginal utility, such an effect is particularly detrimental to the indirect utility of poorer individuals. Furthermore, markups act as a distortion on labor supply and, thus, have a negative impact on efficiency.1 Overall, rising markups may create a case for the government to utilize its tax policies in order to re-optimize the trade-off between equity and efficiency. The literature that considers redistributive taxation in conjunction with market power either conducts policy experiments with the profit tax (Boar and Midrigan 2019) or exclusively focuses on income taxes in settings where 100% profit tax is optimal (Kaplow 2019; Kushnir and Zubrickas 2019). It might, however, prove important to consider the interplay between the two policy tools. Ultimately, the two taxes jointly determine the state of competition and the total tax revenue in an economy. I explicitly model the strategic interactions between firms in a monopolistic competition setting in order to study the joint optimization of income and profit taxation. Atesagaoglu and Yazici (2020) explore the ramifications of higher markups for optimal capital and labor income taxation. Their study, however, abstracts from redistributive concerns. Scheuer (2014) studies simultaneous optimization of labor income and profit taxes in a setting with perfect competition. The purpose of this study, on the other hand, is to account for the redistributive taxation implications of market imperfections brought about by increasing markups. How does a government with redistributive motives optimally adjust its corporate profit and labor income tax mix as markups rise? Should the corporate profit tax decrease to stimulate competition or should it increase to extract higher profit tax revenues that can be redistributed to the needy? What is the role of optimal Mirrleesian income taxes? This study investigates the optimal policy rules that address these questions. I utilize a general equilibrium model featuring individuals that are heterogeneous in their earning abilities. Production is performed in two stages. A finite set of monopolistically competitive firms supply intermediate goods by using labor as the only input. This sector exhibits endogenous firm entry and, hence, generates endogenous markups which decrease in the number of firms. The final good producer aggregates the intermediate inputs in a perfectly competitive environment and sells the final goods to the individuals. A utilitarian government maximizes social welfare by simultaneously choosing its flat profit tax rate and Mirrleesian labor income tax scheme. 1 Barkai (2020) and Loecker et al. (2020) argue that the profit share in the US economy has been increasing at the expense of the labor share since the 80s. 13 Rising markups and optimal redistributive taxation Crucially, an increase in fixed production costs in the intermediate goods sector reduces the number of firms (i.e., by distorting R&D activities) and increases the wedge between prices and marginal costs. Whereas marginal costs of intermediate goods firms correspond to the wage rates of the individuals, prices of the intermediate goods factor into the cost-of-living. As a result, the real wages of the individuals decline. Furthermore, the reduction in real wages acts as a distortion of labor supply due to the substitution effect and, hence, leads to efficiency losses. Novel formulas for optimal profit and labor income taxes are presented in a stylized two-type model. The optimal profit tax primarily depends on three factors: (i) the Price Effect, (ii) the Tax Base Effect and (iii) the social value of taxable profits. Accordingly, (i) captures the distortive effects of the profit tax on competition, which leads to higher equilibrium cost-of-living. Thus, greater (i) tends to reduce the optimal profit tax. Furthermore, (ii) and (iii) are related to the redistributive prospects and contribute to an increase in the profit tax. The sign and magnitude of the optimal profit tax are determined by the counteraction of these two motives. The expression for optimal marginal labor income taxes, on the other hand, incorporates an additional term to the standard Stiglitz (1982) formula. This new term tends to reduce labor distortions as markups increa (...truncated)