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Federal Reserve Bank of Atlanta
FRB Atlanta Working Paper
Optimal Fiscal Policy with Recursive Preferences
Anastasios G. Karantounias

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.

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Anastasios G. Karantounias, Optimal Fiscal Policy with Recursive Preferences, Federal Reserve Bank of Atlanta, FRB Atlanta Working Paper 2013-07, 01 Sep 2013, revised 01 Jan 2018.
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Keywords: Ramsey plan; tax smoothing; Epstein-Zin; recursive utility; excess burden; labor tax; capital tax; martingale; fiscal insurance
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