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This paper employs a stochastic endogenous growth model with productive government expenditure to analyze the macroeconomic effects of income taxation. We demonstrate that in the presence of capital and income risk the impact of taxation on consumption choice as well as on economic growth is ambiguous as it affects the mean as well as the variance of disposable income. It is possible to solve for welfare-maximizing policies, but contrary to the deterministic framework, welfare-, consumption- and growth-maximizing policies do not necessarily coincide. Multiple solutions for optimal tax rates can be found. The risk premium turns out to be a key factor in explaining the effects. In fact, growth-maximizing policies also maximize the risk premium. This may entail too much risk for risk-averse agents, thereby minimizing welfare and the propensity to consume.

Income Taxation, Productive Government Expenditure and Stochastic Growth: On Conditions for an Optimal Policy and the Role of the Risk Premium