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Optimal Fiscal Policy with Robust Control

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Executive Summary

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. The author considers 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.

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