Recursive utility, productive government expenditure and optimal fiscal policy

Abstract

This paper employs a stochastic endogenous growth model extended to the case of a recursive utility function which can disentangle intertemporal substitution from risk aversion to analyze productive government expenditure and optimal fiscal policy, particularly stresses the importance of factor income. First, the explicit solutions of the central planner's stochastic optimization problem are derived, the growth-maximizing and welfare-maximizing government expenditure policies are obtained and their standing in conflict or coincidence depends upon intertemporal substitution. Second, the explicit solutions of the representative individual's stochastic optimization problem which permits to tax on capital income and labor income separately are derived, and it is found that the effect of risk on growth crucially depends on the degree of risk aversion, the intertemporal elasticity of substitution and the capital income share. Finally, a flexible optimal tax policy which can be internally adjusted to a certain extent is derived, and it is found that the distribution of factor income plays an important role in designing the optimal tax policy.