This paper studies the design of optimal fiscal policy when a government that fully trusts the probability model of government expenditures faces a fearful public that forms pessimistic expectations. We identify two forces that shape our results. On the one hand, the government has an incentive to concentrate tax distortions on events that it considers unlikely relative to the pessimistic public. On the other hand, the endogeneity of the public's expectations gives rise to a novel motive for expectation management that aims toward the manipulation of equilibrium prices of government debt in a favorable way. These motives typically act in opposite directions and induce persistence to the optimal allocation and the tax rate.

When the intertemporal elasticity of substitution is disentangled from risk aversion as in the recursive preferences of Epstein and Zin (1989) and Weil (1990), news about the intertemporal profile of consumption and leisure affect the equilibrium value of the government's portfolio of securities and, therefore, the extent to which the government has to resort to distortionary taxation in order to finance government expenditures. This paper studies the implications of this channel for the optimal capital and labor income taxation over the business cycle. In contrast to the case of time-additive expected utility, the excess burden of taxation becomes time-varying and persistent, causing taxation at the intertemporal margin and variation of taxation at the intratemporal margin. JEL classification: D80; E62; H21; H63.

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This paper analyzes optimal fiscal policy with ambiguity aversion and endogenous government spending. We show that without ambiguity, optimal surplus-to-output ratios are acyclical and that there is no rationale for either reduction or further accumulation of public debt. In contrast, ambiguity about the cycle can generate optimally policies that resemble “austerity” measures. Optimal policy prescribes higher taxes in adverse times and front-loaded fiscal consolidations that lead to a balanced primary budget in the long run. This is the case when interest rates are sufficiently responsive to cyclical shocks, that is, when the intertemporal elasticity of substitution is sufficiently low. (JEL D81, E32, E43, E62, H21, H61, H63)

When the intertemporal elasticity of substitution is disentangled from risk aversion as in the recursive preferences of Epstein and Zin (1989) and Weil (1990), news about the intertemporal profile of consumption and leisure affect the equilibrium value of the government's portfolio of securities and, therefore, the extent to which the government has to resort to distortionary taxation in order to finance government expenditures. This paper studies the implications of this channel for the optimal capital and labor income taxation over the business cycle. In contrast to the case of time-additive expected utility, the excess burden of taxation becomes time-varying and persistent, causing taxation at the intertemporal margin and variation of taxation at the intratemporal margin.