Income tax reductions in production networks

Abstract

We analytically characterize the comparative statics of the macroeconomy after income tax reductions in which production is organized in networks around the inefficient economy. We contribute to the literature by showing that in production networks, income taxes have different effects from revenue taxes which are assumed to be real distortions in the literature. The sectoral income tax reductions’ first-order effect on the GDP is given by a sufficient statistics: the product of the sectoral labor demand elasticity and sectoral Domar weight minus the sectoral labor share in the total labor supply, the latter of which is adjusted for labor supply elasticity if labor is elastic. We apply this model to quantify the effects of income tax reductions during the COVID-19 pandemic in the USA.