Optimal Contingent Fiscal Policy in a Business Cycle Model

The indeterminacy of the optimal fiscal policy that emerges in a stochastic setting has been characterized by Zhu (1992) and Chari, Christiano and Kehoe (1994). There are infinite paths of ex-post capital income tax rates and state-contingent debt return supporting the optimal allocations of consumption, investment and leisure. The main goal of this paper is to introduce identification constraints to determine the state-contingent fiscal policy and to characterize its cyclical properties. Two types of identification constraint will be considered: constraints on the stability of the debt path and constraints on the expectation mechanism. Results indicate that, independently of the identification constraint, the optimal ex-post capital income tax rate is zero and does not fluctuate. * We are grateful to Alfonso Novales, Víctor Ríos-Rull and Javier Vallés for helpful comments and suggestions. Financial support from Spanish Ministry of Education through grant SEC1999-1094 is gratefully acknowledged.