Optimal Fiscal Policy with Robust Control

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.