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.