Optimal tax policy under habit formation and capital utilization

• In the presence of productivity growth, habit formation reduces capital utilization and increases the stock of capital.
• The presence of endogenous capital utilization does not change the Chamley–Judd result of zero income capital taxation.
• This result extends to the short-run as long as there are no depreciation allowances, but breaks if those are present.
• Changes in income tax do not affect capital utilization in the long run, but do so on impact because capital is fixed

Our objective is to investigate, how the combination of habit formation with endogenous capital utilization decisions affects the process of economic growth. We find that in the presence of positive productivity growth, habit formation in consumption reduces the rate of capital utilization while increasing the long run stock of capital. We show in the Chamley–Judd result of zero income capital taxation is robust to the presence of endogenous capital utilization. The result even extends to the short-run as long as there are no depreciation allowances, but breaks if those are present. Our policy simulations show that steady state level of capital utilization is not affected by changes in income tax, but its reduced on impact to accommodate for the constance of capital stock Our numerical simulations also show important differences in the time adjustment followed by key variables, as a response to tax policy.