Are State and Provincial Governments Tax Smoothing? Evidence from Panel Data

Abstract

The theory of debt examined here is known variously as taxation over time, optimal taxation over time, the equilibrium approach to fiscal policy, or smoothing. Tax smoothing results when an efficient government fixes tax rates today to minimize the costs of taxation over time. Given the long-run constraint of a balanced budget, if the marginal costs of taxation are an increasing function of the amount of resources taxed (i.e., the rate), then minimization of the total costs of taxation implies that the planned tax rate will be constant over time. Tax rate changes will be unpredictable and the tax rate will behave as a random walk. Efficient governments will not adjust tax rates to accommodate temporary changes in expenditures and revenues. Instead, governments will minimize tax rate changes by smoothing. Smoothing tax rates implies that temporary changes in government spending and output result in deficits and surpluses. Therefore, tax smoothing provides a theory of government The model is primarily due to Barro [1]. The goal of this paper is to contribute to our understanding of government The focus of this paper is on and provincial debt, or what is generally referred to as state and local debt. Nearly every government in the United States has a balanced budget rule. However, balanced budget rules are not sufficient to rule out tax smoothing, as governments could build up budget surpluses in good times to smooth budgets over the business cycle. If governments are smoothing tax rates, then their budget surpluses are endogenous. Contrary to the governments, provincial governments in Canada have no balanced budget rules. If provincial governments are smoothing tax rates, it could explain the behavior of their budget deficits and surpluses. As shown by Barro, tax smoothing implies that the (overall) tax rate behaves as a random walk and the tax rate would be a nonstationary time series with a unit root. This study examines the tax smoothing hypothesis in two ways. First, the random walk implication is examined directly by testing the null hypothesis that the tax rate time series has a unit root. Second, if the tax rate behaves as a random walk, then changes in the tax rate should be unpredictable from past information. If past information can predict tax rate changes, this would provide evidence in favor of an alternative hypothesis. A rejection of tax smoothing suggests that and provincial tax rates respond to current