Optimal time-consistent fiscal policy under endogenous growth with elastic labor supply

- We characterize the optimal time-consistent policy in an endogenous growth model.
- The Markov-perfect policy implies a higher income tax rate than the Ramsey solution.
- The Markov policy allocates a larger share of government spending to consumption.
- A higher preference for leisure leads to a lower optimal income tax rate.
- A higher preference for leisure reduces public consumption to total spending ratio.

We explore the implications of incorporating an elastic labor supply in an endogenous growth economy when characterizing the time-consistent Markov policy. We consider two policy instruments: an income tax rate and the split of government spending between consumption and production services. The Markov-perfect policy implies a higher income tax rate and a larger proportion of government spending allocated to consumption than those chosen under a commitment constraint on the part of the government. As a consequence, economic growth is slightly lower under the Markov-perfect policy than under the Ramsey policy. Under the Markov and Ramsey optimal policies, a higher weight of leisure in households' preferences leads to a lower optimal income tax rate and a lower proportion of public resources devoted to consumption. We also show that the policy bias that would arise when imposing a Markov policy designed ignoring the presence of leisure in the utility function would lead to a significant welfare loss.