Optimal fiscal policy with recursive preferences
When the intertemporal elasticity of substitution is disentangled from risk aversion as in the recursive preferences of Epstein and Zin (1989) and Weil (1990), news about the intertemporal profile of consumption and leisure affect the equilibrium value of the government's portfolio of securities and, therefore, the extent to which the government has to resort to distortionary taxation in order to finance government expenditures. This paper studies the implications of this channel for the optimal capital and labor income taxation over the business cycle. In contrast to the case of time-additive expected utility, the excess burden of taxation becomes time-varying and persistent, causing taxation at the intertemporal margin and variation of taxation at the intratemporal margin. Optimal labor taxes become endogenously persistent.
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