Optimal Fiscal Policy with Incomplete Financial Markets

Abstract

This paper studies the optimal design of fiscal policy when financial markets are incomplete at the aggregate and microeconomic level. The government trades a non-state contingent bond (liability) and cannot insure against the uncertainty in future tax revenues, while households are unable to insure against their risk to human capital investments. Because of this risk, the macroeconomic equilibrium is inefficient since asset prices are affected by the extra volatility in private consumption. This element together with the insurance motive of the government to hedge against the uncertainty in tax revenues determine the allocation of assets and the optimal design of fiscal policies. The results show that the government should accumulate assets in order to smooth taxes on labour income, while it should subsidize physical capital in order to increase an inefficiently low level of wages through higher demand for labour. Assessing optimal policies against a negative economic shock, the key findings suggest that a temporary increase in risk-taking is optimal, though not so much through leverage but by a tax policy that incentivise the rebalancing of portfolios towards riskier (but more productive) real assets such as human capital.