Government, Distributive Tax Policy and the Dynamic Inefficiency of Capitalism

Abstract

This paper considers the dynamic inefficiency of capitalism, that is exhibited in Lancaster's paper as the underinvestment of capital stock compared to the social optimum, in the presence of the government that cares for the welfare of workers as well as that of capitalists. This paper shows that the inefficiency arises because the determining factor in Nash equilibrium is the value of the maximum portion of output that workers can consume at each point while in Command equilibrium it is the relative weights assigned to the welfare of workers and capitalists in the government objective function. We investigate the factors that influence the inefficiency with particular attention being given to the switching points at which capital stock stops accumulating. The analysis also considers the coordinating role of government by showing that the optimal tax policy improves on Nash equilibrium by sacrificing production efficiency to achieve distributional goal.