Structural breaks, debt limits and the tax smoothing hypothesis: theory and evidence from the OECD countries

Abstract

In this paper, we consider the Aiyagari et al. (J Polit Econ 110(6):1220–1254, 2002) general equilibrium model of optimal taxation and show that the optimal tax rate does not necessarily imply tax smoothing, as it may depend on past government debt and can also shift with news about future changes in fiscal policy. We test these predictions using data from a sample of 22 OECD countries. When we account for structural breaks in the data, we find that the tax smoothing hypothesis is rejected in favor of stationary tax rates in five countries. Further for most countries with stationary tax rates, the debt-to-GDP ratio helps predict their expected future tax rates. That is not the case for the remaining countries whose tax rates appear to be nonstationary.