OUTPUT EXTERNALITIES ON TOTAL FACTOR PRODUCTIVITY

The impact that output has on future total factor productivity is not internalized by competitive agents. As a result, the allocation that a planner would choose cannot be reached as a competitive equilibrium outcome (neither for infinitely lived agents nor for overlapping generations): the market remuneration to capital and labor is too low. The planner's allocation can nonetheless be implemented by a fiscal policy subsidizing the returns to savings and the wage rate as needed. The exact policy differs depending on whether only past investment or total output influences productivity: in the first case only capital returns need to be subsidized, whereas in the second case labor income needs to be subsidized too. The policy is balanced period by period by means of a lump-sum tax.