Optimal Fiscal Policy with Recursive Preferences

Anastasios G. Karantounias
Working Paper 2013-7b
September 2013 (Revised March 2017)

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I study the implications of recursive utility for the design of optimal fiscal policy. Standard Ramsey tax-smoothing prescriptions are dramatically altered. The planner taxes less in bad times and more in good times, mitigating the effects of shocks. For standard calibrations, labor tax volatility is orders of magnitude larger than in the time-additive case. 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 an even stronger use of debt returns as a fiscal absorber, leading to the conclusion that actual fiscal policy is even worse than we thought.

JEL classification: D80, E62, H21, H63

Key words: Ramsey plan, tax smoothing, Epstein-Zin, recursive utility, excess burden, labor tax, capital tax, martingale, fiscal insurance

The author is grateful to the editor (Philipp Kircher) and to three anonymous referees for insightful comments. He also thanks Roc Armenter, David Backus, Pierpaolo Benigno, R. Anton Braun, Vasco Carvalho, Lawrence Christiano, Lukasz Drozd, Kristopher S. Gerardi, Mikhail Golosov, Jonathan Halket, Lars Peter Hansen, Karen Kopecky, Hanno Lustig, Juan Pablo Nicolini, Demian Pouzo, Victor Rios-Rull, Richard Rogerson, Thomas J. Sargent, Yongseok Shin, and Stanley E. Zin. He also thanks Christopher Sleet for his discussion, seminar participants at Carnegie Mellon University, the Einaudi Istitute of Economics and Finance, the European University Institute, the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of St Louis, LUISS Guido Carli University, the University of California at Davis, the University of Hong Kong, the University of Oxford, Universitat Pompeu Fabra, the University of Reading, and conference participants at the first 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, anastasios.karantounias@atl.frb.org.
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