This paper studies the design of optimal fiscal policy when a government that fully trusts the probability model of government expenditures faces a fearful public that forms pessimistic expectations. We identify two forces that shape our results. On the one hand, the government has an incentive to concentrate tax distortions on events that it considers unlikely relative to the pessimistic public. On the other hand, the endogeneity of the public’s expectations gives rise to a novel motive for expectation management that aims towards the manipulation of equilibrium prices of government debt in a favorable way. These motives typically act in opposite directions and induce persistence to the optimal allocation and the tax rate.
JEL classification: D80; E62; H21; H63
Key words: Fiscal policy, misspecification, robustness, taxes, debt, martingale
This paper circulated previously under the titles "Ramsey taxation and fear of misspecification" and "Managing expectations and fiscal policy." I would like to thank Lars Peter Hansen and Thomas J. Sargent for their invaluable help at early stages of this project. I am grateful to the Co-editor, Gadi Barlevy, and to two anonymous referees for their generous and insightful comments that led to a substantial improvement of the paper. I am thankful to David Backus, Marco Bassetto, Pierpaolo Benigno, Marco Cagetti, Steven Coate, Kristopher S. Gerardi, Ricardo Lagos, Andreas Lehnert, Guido Lorenzoni, James M. Nason, Monika Piazzesi, William Roberds, John Rust, Martin Schneider, John Shea, Karl Shell, Ennio Stacchetti, Thomas D. Tallarini, Jr., Viktor Tsyrennikov, Tao Zha and to seminar participants at Birkbeck College, Cornell University, Einaudi Institute of Economics and Finance, the Federal Reserve Board of Governors, the Federal Reserve Banks of Atlanta and Chicago, the University of Iowa, the University of Maryland, New York University, the University of Oxford, the Pennsylvania State University, the University of Warwick and the Wharton School. I would like to thank, without implicating, the Research and Statistics Division of the Federal Reserve Board and the Monetary Policy Strategy Division of the European Central Bank for their hospitality and support. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.