Optimal Capital Taxation and Consumer Uncertainty

This paper analyzes the impact of consumer uncertainty on optimal fiscal policy in a model with capital. The consumers lack confidence about the probability model that characterizes the stochastic environment and so apply a max-min operator to their optimization problem. An altruistic fiscal authority does not face this Knightian uncertainty. It is shown analytically that the government, in responding to consumer uncertainty, no longer sets the expected capital tax rate exactly equal to zero, as is the case in the full-confidence benchmark model. However, our numerical results indicate that the government does not diverge far from this value. Even though the capital income tax rate is close to zero in expectation, consumer uncertainty leads the altruistic government to implement a more volatile capital tax rate across states. In doing so, the government relies more heavily on the capital tax and, consequently, less heavily on the labor income tax to finance the shock to public spending