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.
JEL classification: D80; E62; H21; H63
Key words: Ramsey plan, Epstein-Zin, recursive utility, risk-sensitive preferences, labor tax, capital tax, martingale
The first draft of this paper was published in April 2010. The author thanks David Backus, Pierpaolo Benigno, Vasco Carvalho, Lawrence Christiano, Kristopher S. Gerardi, Lars Peter Hansen, Juan Pablo Nicolini, Demian Pouzo, Victor Rios-Rull, Richard Rogerson, Thomas J. Sargent, and Stanley E. Zin. He also thanks seminar participants at the University of California at Davis, Carnegie Mellon University, Universitat Pompeu Fabra, the European University Institute, LUISS Guido Carli University, and the University of Hong Kong, and conference participants at the first New York University Alumni Conference, the CRETE 2011 Conference, the 2012 SED Meetings, the 2012 EEA Annual Congress, and the 2013 AEA meetings. He is grateful to Christopher Sleet for his discussion at the AEA Meetings in San Diego. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
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