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Optimal Fiscal Policy with Recursive Preferences
Journal article   Peer reviewed

Optimal Fiscal Policy with Recursive Preferences

Anastasios G Karantounias
The Review of Economic Studies, Vol.85(4), pp.2283-2317
10/2018

Abstract

E62 Tax smoothing Epstein-Zin H63 Ramsey plan Capital tax H21 Martingale Labour tax Excess burden Fiscal insurance Recursive utility D80

I study the implications of recursive utility, a popular preference specification in macro-finance, for the design of optimal fiscal policy. Standard Ramsey tax-smoothing prescriptions are substantially altered. The planner over-insures 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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