The production side of the OG-Core model is populated by \(M\) industries indexed by \(m=1,2,...M\), each of which industry has a unit measure of identical perfectly competitive firms that rent private capital \(K_{m,t}\) and public capital \(K_{g,m,t}\) and hire labor \(L_{m,t}\) to produce output \(Y_{m,t}\). Firms face a flat corporate income tax \(\tau^{corp}_{m,t}\) and can deduct capital expenses for tax purposes at a rate \(\delta^\tau_{m,t}\). Tax parameters can vary by industry \(m\) and over time, \(t\).

Production Function#

Firms in each industry produce output \(Y_{m,t}\) using inputs of private capital \(K_{m,t}\), public capital \(K_{g,m,t}\), and labor \(L_{m,t}\) according to a general constant elasticity (CES) of substitution production function,

(40)#\[\begin{split} \begin{split} Y_{m,t} &= F(K_{m,t}, K_{g,m,t}, L_{m,t}) \\ &\equiv Z_{m,t}\biggl[(\gamma_m)^\frac{1}{\varepsilon_m}(K_{m,t})^\frac{\varepsilon_m-1}{\varepsilon_m} + (\gamma_{g,m})^\frac{1}{\varepsilon_m}(K_{g,m,t})^\frac{\varepsilon_m-1}{\varepsilon_m} + \\ &\quad\quad\quad\quad\quad(1-\gamma_m-\gamma_{g,m})^\frac{1}{\varepsilon_m}(e^{g_y t}L_{m,t})^\frac{\varepsilon_m-1}{\varepsilon_m}\biggr]^\frac{\varepsilon_m}{\varepsilon_m-1} \quad\forall m,t \end{split}\end{split}\]

where \(Z_{m,t}\) is an exogenous scale parameter (total factor productivity) that can be time dependent, \(\gamma_m\) represents private capital’s share of income, \(\gamma_{g,m}\) is public capital’s share of income, and \(\varepsilon_m\) is the constant elasticity of substitution among the two types of capital and labor. We have included constant productivity growth rate \(g_y\) as the rate of labor augmenting technological progress.

A nice feature of the CES production function is that the Cobb-Douglas production function is a nested case for \(\varepsilon_m=1\).[1]

(41)#\[ Y_{m,t} = Z_{m,t} (K_{m,t})^{\gamma_m} (K_{g,m,t})^{\gamma_{g,m}}(e^{g_y t}L_{m,t})^{1-\gamma_m-\gamma_{g,m}} \quad\forall m,t \quad\text{for}\quad \varepsilon_m=1\]

Industry \(M\) in the model is unique in two respects. First, we will define industry \(M\) goods as the numeraire in OG_Core. Therefore, all quantities are in terms of industry \(M\) goods and all prices are relative to the price of a unit of industry \(M\) goods. Second, the model solution is greatly simplified if just one production industry produces capital goods. The assumption in OG-Core is that industry \(M\) is the only industry producing capital goods (though industry \(M\) goods can also be used for consumption).

Optimality Conditions#

The static per-period profit function of the representative firm in each industry \(m\) is the following.

(42)#\[\begin{split} PR_{m,t} &= (1 - \tau^{corp}_{m,t})\Bigl[p_{m,t}F(K_{m,t},K_{g,m,t},L_{m,t}) - w_t L_{m,t}\Bigr] - \\ &\qquad\qquad\quad \bigl(r_t + \delta_{M,t}\bigr)K_{m,t} + \tau^{corp}_{m,t}\delta^\tau_{m,t}K_{m,t} + \tau^{inv}_{m,t}\delta_{M,t}K_{m,t} \quad\forall m,t\end{split}\]

Gross income for the firms is \(p_{m,t}F(K_{m,t},K_{g,m,t},L_{m,t})\). Labor costs to the firm are \(w_t L_{m,t}\), and capital costs are \((r_t +\delta_{M,t})K_{m,t}\). The government supplies public capital \(K_{g,m,t}\) to the firms at no cost. The per-period interest rate (rental rate) of capital for firms is \(r_t\). The per-period economic depreciation rate for private capital is \(\delta_{M,t}\in[0,1]\).[2] The \(\delta^\tau_{m,t}\) parameter in the second-to-last term of the profit function governs how much of capital depreciation can be deducted from the corporate income tax. Note that the last term above represents the benefits from any investment tax credit \(\tau^{inv}_{m,t}\). While this should be applied to all investment, firms in OG-Core are making static decisions each period about the amount of capital to rent. We therefore proxy for investment with \(\delta_{M,t}K_{m,t}\), which is accurate in the steady-state, but is an approximation over the transition to the steady-state.

Taxes enter the firm’s profit function (42) in two places. The first is the corporate income tax rate \(\tau^{corp}_{m,t}\), which is a flat tax on corporate income that can vary by industry \(m\). Corporate income is defined as gross income minus labor costs. This will cause the corporate tax to only have a direct effect on the firms’ capital demand decision.

The tax policy also enters the profit function (42) through depreciation deductions at rate \(\delta^\tau_{m,t}\), which then lower corporate tax liability. When \(\delta^\tau_{m,t}=0\), no depreciation expense is deducted from the firm’s tax liability. When \(\delta^\tau_{m,t}=\delta_{M,t}\), all economic depreciation is deducted from corporate income. The investment tax credit is characterized by the parameter \(\tau^{inv}_{m,t}\) multiplied by a proxy for investment \(\delta_{M,t}K_{m,t}\) by industry \(m\), which represents the percent of industry-specific capital that can be credited against profits.

Firms take as given prices \(p_{m,t}\), \(w_t\), and \(r_t\) and the level of public capital supply \(K_{g,m,t}\). Taking the derivative of the profit function (42) with respect to labor \(L_{m,t}\) and setting it equal to zero (using the general CES form of the production function (40)) and taking the derivative of the profit function with respect to private capital \(K_{m,t}\) and setting it equal to zero, respectively, characterizes the optimal labor and capital demands.

(43)#\[ w_t = e^{g_y t}p_{m,t}(Z_{m,t})^\frac{\varepsilon_m-1}{\varepsilon_m}\left[(1-\gamma_m-\gamma_{g,m})\frac{Y_{m,t}}{e^{g_y t}L_{m,t}}\right]^\frac{1}{\varepsilon_m} \quad\forall m,t\]
(44)#\[ r_t = (1 - \tau^{corp}_{m,t})p_{m,t}(Z_{m,t})^\frac{\varepsilon_m-1}{\varepsilon_m}\left[\gamma_m\frac{Y_{m,t}}{K_{m,t}}\right]^\frac{1}{\varepsilon_m} - \delta_{M,t} + \tau^{corp}_{m,t}\delta^\tau_{m,t} + \tau^{inv}_{m,t}\delta_{M,t} \quad\forall m,t\]

Note that the presence of the public capital good creates economic rents. These rents will accrue to the owners of capital via the financial intermediary. See Section Chapter Financial Intermediary for more details on the determination of the return to the household’s portfolio. Because public capital is exogenous to the firm’s decisions, the optimality condition for capital demand (44) is only affected by public capital \(K_{g,m,t}\) through the \(Y_{m,t}\) term.

Positive Profits from Government Infrastructure Investment#

The CES production function in (40) exhibits constant returns to scale (CRS). A feature of CRS production functions is that gross revenue \(Y_{m,t}\) is a sum of the gross revenue attributed to each factor of production,

(45)#\[ Y_{m,t} = MPK_{m,t} K_{m,t} + MPK_{g,m,t} K_{g,m,t} + MPL_{m,t} L_{m,t} \quad\forall m,t\]

where \(MPK_{m,t}\) is the marginal product of private capital in industry \(m\), \(MPK_{g,m,t}\) is the marginal product of public capital, and \(MPL_{m,t}\) is the marginal product of labor.[3] Each of the terms in (45) is growing at the macroeconomic variable rate of \(e^{g_y t}\tilde{N_t}\) (see the third column of Table 3). Firm profit maximization for private capital demand from equation (44) implies that the marginal product of private capital is equal to the real cost of capital:

(46)#\[ MPK_{m,t} = \frac{r_t + \delta_{M,t} - \tau^{corp}_{m,t}\delta^\tau_{m,t} - \tau^{inv}_{m,t}\delta_{M,t}}{p_{m,t}(1 - \tau^{corp}_{m,t})} \quad\forall m,t\]

Firm profit maximization for labor demand from equation (43) implies that the marginal product of labor is equal to the real wage rate:

(47)#\[ MPL_{m,t} = \frac{w_t}{p_{m,t}} \quad\forall m,t\]

Even though firms take the stock of public capital \(K_{g,t}\) from government infrastructure investment as given, we can still calculate the marginal product of public capital from the production function (40).

(48)#\[ MPK_{g,m,t} = \left(Z_{m,t}\right)^{\frac{\varepsilon_m - 1}{\varepsilon_m}}\left(\gamma_{g,m}\frac{Y_{m,t}}{K_{g,m,t}}\right)^{\frac{1}{\varepsilon_m}} \quad\forall m,t\]

If we plug the expressions for \(MPK_{m,t}\), \(MPK_{g,m,t}\), and \(MPL_{m,t}\) from (46), (48), and (47), respectively, into the total revenue \(Y_{m,t}\) decomposition in (45) and then substitute that into the profit function (42), we see that positive economic rents arise when public capital is positive \(K_{g,m,t}>0\).

(49)#\[\begin{split} \begin{split} PR_{m,t} &= (1 - \tau^{corp}_{m,t})\Bigl[p_{m,t}Y_{m,t} - w_t L_{m,t}\Bigr] - \bigl(r_t + \delta_{M,t}\bigr)K_{m,t} + \tau^{corp}_{m,t}\delta^\tau_{m,t}K_{m,t} + \tau^{inv}_{m,t}\delta_{M,t}K_{m,t} \\ &= (1 - \tau^{corp}_{m,t})\Biggl[\biggl(\frac{r_t + \delta_{M,t} - \tau^{corp}_{m,t}\delta^{\tau}_{m,t} - \tau^{inv}_{m,t}\delta_{M,t}}{1 - \tau^{corp}_{m,t}}\biggr)K_{m,t} + p_{m,t}MPK_{g,m,t}K_{g,m,t} + w_t L_{m,t}\Biggr] ... \\ &\quad\quad - (1 - \tau^{corp}_{m,t})w_t L_{m,t} - (r_t + \delta_{M,t})K_{m,t} + \tau^{corp}_{m,t}\delta^{\tau}_{m,t}K_{m,t} + \tau^{inv}_{m,t}\delta_{M,t}K_{m,t} \\ &= (1 - \tau^{corp}_{m,t})p_{m,t}MPK_{g,m,t}K_{g,m,t} \quad\forall m,t \end{split}\end{split}\]

We assume these positive economic profits resulting from government infrastructure investment are passed on to the owners of private capital through an adjusted interest rate \(r_{K,t}\) provided by the financial intermediary (see Chapter Financial Intermediary) that zeroes out profits among the perfectly competitive firms and is a function of \(p_{m,t}\), \(MPK_{g,m,t}\) and \(K_{g,m,t}\) in each industry \(m\). Total payouts from the financial intermediary \(r_{K,t}\sum_{m=1}^M K_{m,t}\) are a function of the perfectly competitive payout to owners of private capital \(r_t \sum_{m=1}^M K_{m,t}\) plus any positive profits when \(K_{g,m,t}>0\) from (49).

(50)#\[ r_{K,t}\sum_{m=1}^M K_{m,t} = r_t \sum_{m=1}^M K_{m,t} + \sum_{m=1}^M(1 - \tau^{corp}_{m,t})p_{m,t}MPK_{g,m,t}K_{g,m,t} \quad\forall t\]

This implies that the rate of return paid from the financial intermediary to the households \(r_{K,t}\) is the interest rate on private capital \(r_t\) plus the ratio of total positive profits across industries (a function of \(K_{g,m,t}\) in each industry) divided by total private capital from (49), in which the units are put in terms of \(K_{m,t}\) (which is in terms of the \(M\)th industry output, see equation (93) in Chapter Financial Intermediary).

(51)#\[ r_{K,t} = r_t + \frac{\sum_{m=1}^M(1 - \tau^{corp}_{m,t})p_{m,t}MPK_{g,m,t}K_{g,m,t}}{\sum_{m=1}^M K_{m,t}} \quad\forall t\]