Does tax smoothing imply smooth taxes?

Abstract

Using a stochastic growth model subject to shocks to productivity, government expenditure and tastes we derive analytical expressions for optimal labour and capital tax rates. We find labour taxes are driven by two factors: (a) a component reflecting Ramsey efficiency considerations and (b) a component reflecting the financing needs of the government which varies with the excess burden of taxation. In the case of complete markets, when the government can issue fully contingent debt, the government insures against variations in the excess burden of taxation and so taxes change purely for efficiency reasons. Assuming logarithmic utility, both the serial correlation and variance of taxes are directly related to those of employment. As a result, optimal labour taxes can show frequent and predictable changes; can display a strong cyclical pattern and may be more or less volatile than government expenditure. Assuming a balanced growth path is however sufficient to rule out labour taxes following a martingale process. When the government can only issue risk free non-contingent debt then both Ramsey considerations and variations in the excess burden of taxation lead to changes in taxes and so increase tax volatility. The variations in the excess burden introduce a martingale component to labour taxes. The relative importance of this martingale component is positively related to uncertainty concerning government expenditure while the importance of the Ramsey component depends positively on the excess burden of taxation