Optimal Dynamic Income Taxation Under Quasi‐Hyperbolic Discounting and Idiosyncratic Productivity Shocks

ABSTRACT In the context of a dynamic (three‐period) general equilibrium model, this paper examines the optimal tax rates on capital savings and labor income under quasi‐hyperbolic discounting and idiosyncratic productivity shocks. In the absence of skill‐type uncertainty, we analytically show that the marginal capital tax wedges on agents' first‐period savings are negative for correcting inherent preference internalities and that these tax rates will be higher when productivity disturbances are incorporated. In the stochastic two‐type setting with exogenously‐given factor input prices, our calibrated numerical experiments find that the marginal capital wedges for both types on their period‐1 savings are positive, indicating the government's motive to relax individuals' incentive‐compatibility constraints. We also quantitatively find that the optimal tax rates for both types on their first‐ and second‐period capital savings are ceteris paribus decreasing in the degree of quasi‐hyperbolic discounting because of a stronger need to rectify negative utility internalities.