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Optimal Fiscal Policy with Robust Control

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  • Justin Svec

    ()
    (Department of Economics, College of the Holy Cross)

Abstract

This paper compares the fiscal policies implemented by two types of government when confronted by consumer uncertainty. Consumers, lacking confidence in their knowledge of the stochastic environment, endogenously tilt their subjective probability model away from an approximating probability model. The government does not face this uncertainty. Through its choice of a labor tax and the supply of one-period public debt, the government manipulates the competitive equilibrium allocation and the consumers' probability distortion. I consider two types of altruistic government. A "benevolent" government maximizes the consumers' expected utility under the approximating probability model, whereas a "political" government maximizes the consumers' expected utility under the consumers' subjective probability model. I find that, relative to a full-confidence setup, the benevolent government relies more heavily on labor taxes to finance fluctuations in spending, while the political government depends more on public debt to absorb the fiscal shock. These policies are designed to re-align the consumers' savings decisions with their full-confidence values and to reduce the fluctuations in the consumers' welfare across states, respectively.

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File URL: http://college.holycross.edu/RePEc/hcx/Svec_OptimalFiscalPolicy.pdf
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Bibliographic Info

Paper provided by College of the Holy Cross, Department of Economics in its series Working Papers with number 1004.

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Length: 40 pages
Date of creation: Oct 2010
Date of revision:
Handle: RePEc:hcx:wpaper:1004

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Keywords: Robust control; uncertainty; taxes; debt; Ramsey problem;

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References

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  1. Dennis, Richard, 2010. "How robustness can lower the cost of discretion," Journal of Monetary Economics, Elsevier, vol. 57(6), pages 653-667, September.
  2. Narayana Kocherlakota & Christopher Phelan, 2007. "On the Robustness of Laissez-Faire," Levine's Bibliography 843644000000000165, UCLA Department of Economics.
  3. Michael Woodford, 2005. "Robustly optimal monetary policy with near-rational expectations," Discussion Papers 0506-13, Columbia University, Department of Economics.
  4. Richard Dennis & Kai Leitemo & Ulf Söderström, 2006. "Methods for robust control," Working Paper Series 2006-10, Federal Reserve Bank of San Francisco.
  5. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal Fiscal Policy in a Business Cycle Model," NBER Working Papers 4490, National Bureau of Economic Research, Inc.
  6. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  7. Albert Marcet & Ramon Marimon, 1994. "Recursive contracts," Economics Working Papers 337, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 1998.
  8. Orphanides, Athanasios & Williams, John C., 2007. "Robust monetary policy with imperfect knowledge," Working Paper Series 0764, European Central Bank.
  9. Richard Dennis, 2008. "Model Uncertainty and Monetary Policy," NCER Working Paper Series 30, National Centre for Econometric Research.
  10. Hansen, Lars Peter & Sargent, Thomas J., 2005. "Recursive robust estimation and control without commitment," Discussion Paper Series 1: Economic Studies 2005,28, Deutsche Bundesbank, Research Centre.
  11. Anastasios G. Karantounias with Lars Peter Hansen & Thomas J. Sargent, 2009. "Managing expectations and fiscal policy," Working Paper 2009-29, Federal Reserve Bank of Atlanta.
  12. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  13. Hansen, Lars Peter & Sargent, Thomas J., 2005. "Robust estimation and control under commitment," Journal of Economic Theory, Elsevier, vol. 124(2), pages 258-301, October.
  14. Camerer, Colin & Weber, Martin, 1992. " Recent Developments in Modeling Preferences: Uncertainty and Ambiguity," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 325-70, October.
  15. Justin Svec, 2011. "Optimal Capital Taxation and Consumer Uncertainty," Working Papers 1108, College of the Holy Cross, Department of Economics.
  16. Hansen, Lars Peter & Sargent, Thomas J. & Turmuhambetova, Gauhar & Williams, Noah, 2006. "Robust control and model misspecification," Journal of Economic Theory, Elsevier, vol. 128(1), pages 45-90, May.
  17. Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
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Citations

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Cited by:
  1. Robert Baumann & Justin Svec, 2013. "The Impact of Political Uncertainty: A Robust Control Approach," Working Papers 1306, College of the Holy Cross, Department of Economics.
  2. Joshua Congdon-Hohman & Anil Nathan & Justin Svec, 2013. "Student Uncertainty and Major Choice," Working Papers 1301, College of the Holy Cross, Department of Economics.
  3. Ryan Chahrour & Justin Svec, 2014. "Optimal Capital Taxation and Consumer Uncertainty," Boston College Working Papers in Economics 854, Boston College Department of Economics.
  4. Woodford, Michael, 2005. "Robustly optimal monetary policy with near-rational expectations," CFS Working Paper Series 2007/12, Center for Financial Studies (CFS).
  5. Richard Dennis, 2013. "Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive," Working Papers 2013_15, Business School - Economics, University of Glasgow.
  6. Konstantinos Angelopoulos & George Economides & Apostolis Philippopoulos, 2012. "Public Good Provision with Robust Decision Making," CESifo Working Paper Series 3996, CESifo Group Munich.
  7. Yulei Luo & Jun Nie & Eric R. Young, 2012. "Model uncertainty and intertemporal tax smoothing," Research Working Paper RWP 12-01, Federal Reserve Bank of Kansas City.
  8. Young, Eric R., 2012. "Robust policymaking in the face of sudden stops," Journal of Monetary Economics, Elsevier, vol. 59(5), pages 512-527.

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