Optimal Fiscal Policy with Recursive Preferences
91 Pages Posted: 30 Aug 2013 Last revised: 16 Dec 2017
Date Written: October 23, 2017
I study the implications of recursive utility, a popular preference specification in macro-finance, for the design of optimal fiscal policy. Standard Ramsey tax-smoothing prescriptions are substantially altered. The planner over-insures by taxing less in bad times and more in good times, mitigating the effects of shocks. At the intertemporal margin, there is a novel incentive for introducing distortions that can lead to an ex-ante capital subsidy. Overall, optimal policy calls for a much stronger use of debt returns as a fiscal absorber, leading to the conclusion that actual fiscal policy is even worse than we thought.
Keywords: Ramsey plan, tax smoothing, Epstein-Zin, recursive utility, excess burden, labor tax, capital tax, martingale, fiscal insurance.
JEL Classification: D80, E62, H21, H63
Suggested Citation: Suggested Citation