Misallocation in a model with endogenous managerial Capital and Distortions

Abstract

Aggregate total factor productivity (TFP) differences across countries have been widely recognized as the primary source of huge divergence in per capita income across countries. The misallocation literature has found distortions that inefficiently allocate resources across production units can result in a significant aggregate productivity loss, even without deterioration in the underlying productivity distribution. However, with endogenous managerial capital investment decisions, distortions affect the underlying productivity distribution in addition to reallocating resources across production units.

The first chapter quantifies the effect of progressive taxation in a model with endogenous managerial capital investment decisions. Compared to proportional taxation that raises the same tax revenue, progressive taxation distorts the economy more severely. The more progressive is taxation, the less incentive agents have to invest in their managerial capital. This follows because higher managerial capital implies higher profit, which induces higher tax rates. Thus, compared to a proportional tax regime that raises the same tax revenue, under progressive taxation, agents invest less in their managerial capital and the distribution of income is less dispersed. In addition, the equilibrium values of TFP, total output, employment share of large firms are distorted relative to their values under proportional taxation. Hence, progressive taxation improves equality in the economy in exchange for efficiency.

In the second chapter I examine the effects of credit constraint in a model with endogenous managerial capital investment decisions. If agents can optimally invest in their managerial capital, limited access to physical capital will encourage managers to substitute away from physical capital to investment in managerial capital. The accumulation of managerial capital and the change in the underlying productivity distribution will mitigate the adverse effects of misallocation caused by the credit constraint on the economy. Using calibration, I show that measured TFP could improve with a tighter credit constraint.

The third chapter adds stochastic component to the model with endogenous managerial capital investment decision and credit constraints. I find that with sufficiently large second moment shock to the managerial skill accumulation function, the mitigation effect induced by optimal managerial capital investment decision is itself mitigated.