Journal Article

Optimal Fiscal Policy with Recursive Preferences

Anastasios G Karantounias

in The Review of Economic Studies

Volume 85, issue 4, pages 2283-2317
Published in print October 2018 | ISSN: 0034-6527
Published online January 2018 | e-ISSN: 1467-937X | DOI: https://dx.doi.org/10.1093/restud/rdy005
Optimal Fiscal Policy with Recursive Preferences

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  • Information, Knowledge, and Uncertainy
  • Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
  • Taxation, Subsidies, and Revenue
  • National Budget, Deficit, and Debt

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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; D80; E62; H21; H63

Journal Article.  16892 words.  Illustrated.

Subjects: Information, Knowledge, and Uncertainy ; Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook ; Taxation, Subsidies, and Revenue ; National Budget, Deficit, and Debt

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