Model uncertainty and intertemporal tax smoothing

In this paper we examine how model uncertainty due to the preference for robustness (RB) affects optimal taxation and debt structure in the Barro tax-smoothing model (1979). We first study how the government spending shocks are absorbed in the short run by varying taxes or through debt under RB. Furthermore, we show that introducing RB can improve the model’s predictions by generating (i) the observed relative volatility of the changes in tax rates to government spending and (ii) the observed comovement between government deficits and spending, and (iii) more consistent behavior of government budget deficits.