Optimal Fiscal Policy with Recursive Preferences

Anastasios G. Karantounias
Working Paper 2013-7
September 2013
Revised April 2015

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I study the implications of recursive utility for the design of optimal fiscal policy. I find that the standard policy prescriptions of the dynamic Ramsey literature are dramatically altered. Labor tax volatility is optimal and can be quantitatively substantial. Furthermore, labor taxes are countercyclical, display persistence independent of the stochastic properties of exogenous shocks and increase on average over time. At the intertemporal margin, there is a novel incentive for introducing distortions that can lead to an ex ante capital subsidy. Ignoring the distinction between smoothing over time and smoothing over states is not an innocuous assumption for optimal policy.

JEL classification: D80; E62; H21; H63

Key words: Ramsey plan, Epstein-Zin, recursive utility, risk-sensitive preferences, labor tax, capital tax, martingale

Future versions of the paper can be found on my webpage located at http://www.atl-res.com/~Tasos/.

First draft: April 2010; Current version: October 2014. I am thankful to David Backus, Pierpaolo Benigno, R. Anton Braun, Vasco Carvalho, Lawrence Christiano, Kristopher S. Gerardi, Jonathan Halket, Lars Peter Hansen, Karen Kopecky, Juan Pablo Nicolini, Demian Pouzo, Victor Rios-Rull, Richard Rogerson, Thomas J. Sargent, Stanley E. Zin, to Christopher Sleet for his discussion, to seminar participants at the University of California at Davis, Carnegie Mellon University, Universitat Pompeu Fabra, the European University Institute, LUISS Guido Carli University and the University of Hong Kong and to conference participants at the 1st NYU Alumni Conference, the CRETE 2011 Conference, the 2012 SED Meetings, the 2012 EEA Annual Congress and the 2013 AEA Meetings. 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.
Please address questions regarding content to Anastasios Karantounias, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470, 404-498-8825, anastasios.karantounias@atl.frb.org.
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