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Optimal Fiscal Policy with Recursive Preferences

Anastasios Karantounias ()

Review of Economic Studies, 2018, vol. 85, issue 4, 2283-2317

Abstract: 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.

Keywords: Ramsey plan; Tax smoothing; Epstein-Zin; Recursive utility; Excess burden; Labour tax; Capital tax; Martingale; Fiscal insurance (search for similar items in EconPapers)
JEL-codes: D80 E62 H21 H63 (search for similar items in EconPapers)
Date: 2018
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