Optimal fiscal policy in a model with inherited aspirations and habit formation

In this paper, we analyze optimal fiscal policies in an overlapping generations framework, where preferences exhibit aspirations in consumption and environmental quality as well as habit formation. We focus on the second best policies when the government needs to finance a given stream of public expenditures by using distortionary taxes. We derive necessary and sufficient conditions under which the competitive equilibrium is characterized by levels of capital and environmental quality that are too small and a level of labor supply that is too large. Our numerical simulations show that an optimal fiscal policy can be used as an effective stabilization device and that when consumption taxes are fixed, the planner implements maintenance investment and capital income subsidies while financing public spending through labor and fixed consumption taxes.