Capital Income Taxes and Growth in a Stochastic Economy: A Numerical Analysis of the Role of Risk Aversion and Intertemporal Substitution

This paper undertakes a numerical analysis of the effects of changes in the tax rates on domestic and foreign capital income in a stochastically growing open economy under recursive preferences, in which the rate of time preference, ϵ, and the coefficient of risk aversion, R, can be set independently. The responses of the equilibrium growth rate, its volatility, and welfare to changes in the tax changes considered are highly sensitive to the independent variations in both ϵ and R. Consequently, the errors committed by using the conventional constant elasticity utility function, even for small violations of the compatibility condition (R= 1/ϵ) can be significant, suggesting that this functional form should be employed with caution. Copyright 2004 Blackwell Publishing Inc..