Endogenous markups and the effects of income taxation: Theory and evidence from OECD countries

Existing studies on the effects of fiscal policy under imperfect competition typically treat each firm's price-cost markup as fixed. This paper examines the implications of endogenising the markup in a simple model of income taxation under monopolistic competition. It is demonstrated that an increase in income tax reduces the number of firms, lessens competition among surviving firms and raises the optimal markups in the new steady state. Through this channel, the effects of income taxation on the key macroeconomic variables as well as on consumer welfare are unambiguously enlarged. The simple model prediction is largely supported by cross-section regressions with data from OECD countries. (C) 2000 Elsevier Science S.A. All rights reserved.