Optimal capital taxation and consumer uncertainty

• Consumer uncertainty reduces degree to which labor tax absorbs the fiscal shock.
• Consumer uncertainty increases persistence of optimal labor tax.
• Consumer uncertainty leads planner to subsidize capital at a modest rate.
• Consumer uncertainty increases mean and volatility of the private assets tax.

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. We show analytically that, in responding to consumer uncertainty, the government no longer sets the expected capital tax rate exactly equal to zero, as is the case in the full-confidence benchmark model. Rather, our numerical results indicate that the government chooses to subsidize capital income, albeit at a modest rate. We also show that the government responds to consumer uncertainty by smoothing the labor tax across states and by making the labor tax persistent.