Optimal Fiscal Policy with Recursive Preferences

Anastasios Karantounias | Federal Reserve Bank of Atlanta

I study the implications of recursive utility for the design of optimal fiscal policy. Standard Ramsey tax-smoothing prescriptions are dramatically altered. The planner taxes less in bad times and more in good times, mitigating the effects of shocks. For standard calibrations, labor tax volatility is orders of magnitude larger than in the time-additive case. 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 an even stronger use of debt returns as a fiscal absorber, leading to the conclusion that actual fiscal policy is even worse than we thought.