Output externalities on total factor productivity

The impact that output has on future total factor productivity -i.e. the dynamic complementarities shown to be empirically relevant in Cooper and Johri (1997)- 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 are too low. The planner's allocation can nonetheless be implemented by a fiscal policy subsidizing as needed the returns to savings and the wage rate. The exact policy differs depending on whether just past investment or total output influences productivity: in the first case only capital returns need to be subsidized, while 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.