Robust p theory of taxes and debt management

Abstract

We consider the optimal tax and borrowing plan of a government that worries about model uncertainty and seeks robust decisions. Quantitative implications show that the presence of model uncertainty makes the government more willing to borrow and enlarges its debt capacity. Under the worst-case scenario, the marginal benefit of taxation and the optimal tax rate decreases first and then increases. This is due to the game between two opposing effects induced by ambiguity. Moreover, the government should engage more in financial hedging while the amount of holdings is no longer linear in the debt-to-GDP ratio.