Working Paper

Optimal Fiscal Policy with Recursive Preferences

Abstract: I study the implications of recursive utility, a popular preference specification in macrofinance, for the design of optimal fiscal policy. Standard Ramsey tax-smoothing prescriptions are substantially altered. The planner overinsures 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 plans; tax smoothing; Epstein-Zin; recursive utility; excess burden; labor tax; capital tax; martingale; fiscal insurance;

JEL Classification: D80; E62; H21; H63;

Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta Working Paper

Publication Date: 2015-04-01

Number: 2013-07

Pages: 91 pages