Optimal Fiscal Policy with Recursive Preferences

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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