Working Paper, Federal Reserve Bank of Atlanta 2013-7
I study optimal capital and labor income taxation in a business cycle model with the recursive preferences of Epstein and Zin (1989) and Weil (1990). In contrast to the case of time-additive expected utility, I find that it is no longer optimal to make the welfare cost of distortionary taxes constant over states and dates. This dramatically alters standard taxation prescriptions: optimal policy calls for taxation at the intertemporal margin, variation of taxation at the intratemporal margin, and persistence of labor taxes independent of the stochastic properties of exogenous shocks. Ignoring the distinction between smoothing over time and smoothing over states is not an innocuous assumption for optimal policy.
Ramsey plan Epstein-Zin recursive utility risk-sensitive preferences labor tax capital tax martingale