Optimal fiscal policy and model uncertainty

This dissertation examines fiscal policy from both a theoretical and a numerical perspective. The first two chapters focus on characterizing optimal fiscal policy in an environment of consumer uncertainty, while the third explores the fiscal policies implemented by US state governments.;The first chapter compares the fiscal policies implemented by two types of government when confronted by consumer uncertainty. Consumers, lacking confidence in their understanding of the stochastic environment, distort their subjective probability model. The government does not face this uncertainty. Through its choice of a labor tax and a supply of one-period bonds, the government manipulates the competitive equilibrium allocation and the consumers' probability distortion. I consider two types of altruistic government. The 'benevolent' government maximizes the consumers' expected utility under the true probability model, whereas the 'political' government maximizes the consumers' expected utility under the distorted probability model. I find that, relative to rational expectations, 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 influence the consumers' savings decisions and probability distortion.;The second chapter 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 environment and so apply a max-min operator to their optimization problem. The fiscal authority does not face this Knightian uncertainty. It is shown that a government that maximizes the consumers' expected utility under the distorted probability model sets the expected capital tax roughly equal to zero. Model uncertainty leads the government to rely more heavily on manipulating bond returns and ex-post capital taxes to finance a shock to spending. In addition, the correlation between the labor tax and government spending is smaller than in the rational expectations benchmark.;The third chapter exploits differences in the stringency of balanced budget rules across US states to estimate the effect of fiscal policy cyclicality on GSP growth. While most states have passed laws restricting deficits, the nature and strictness of these laws vary greatly. States with more stringent balanced budget restrictions run more pro-cyclical fiscal policy. We use the diversity in these laws as an instrument for the cyclicality of state government spending. We find modest evidence that a more counter-cyclical fiscal policy increases a state's average growth per capita. In fact, our point estimates suggest that a state could increase its annual growth rate by 0.4 percent by relaxing the "ex-post" balanced budget restriction. This estimated effect is statistically significant at the 10 percent level, but loses its significance when we control for the initial debt to GSP ratio.