How to enable hierarchical permalinks for hierarchical taxonomies

This is implemented in WordPress now as of 3.1.

When you register your taxonomy, make sure to set rewrite hierarchical to true as well as the taxonomy itself:

<?php
register_taxonomy('genre',array('book'), array(
'hierarchical' => true, // this makes it hierarchical in the UI
'labels' => $labels,
'show_ui' => true,
'query_var' => true,
'rewrite' => array( 'hierarchical' => true ), // this makes hierarchical URLs
));