Abstract
This paper considers the extent to which the standard argument, that the disproportionate excess burden of taxation suggests the use of tax smoothing in the face of future cost increases, is modified by uncertainty regarding the future. The role of uncertainty and risk aversion is examined using several highly simplified models involving a possible future contingency requiring an increase in tax-financed expenditure.
Highlights
Governments are often faced with the possibility that a future contingency may arise involving higher public expenditure, much uncertainty is usually involved
The size of the potential future tax-financed cost and its associated probability were found to be the major determinants of the optimal policy
This paper has examined the extent to which the standard tax smoothing argument, arising from the disproportional excess burden of taxation, is modified by the existence of uncertainty both about whether the need for extra expenditure will arise, and about the level of expenditure if the need arises
Summary
Governments are often faced with the possibility that higher public expenditure may be needed in the future, much uncertainty is involved. The question arises of how much, if any, tax smoothing to use, by raising current taxes to build up a fund Faced with uncertainty, it is not clear whether governments should take immediate action or wait to collect useful information. Decision makers are more likely to take immediate and larger action, the higher the perceived probability of the contingency arising, the larger the potential cost, and the higher their degree of risk aversion. The models examined in this paper are highly simplified, involving the choice by a single policy-maker or judge faced with information about the probability of a future event and its associated cost. The alternative case of Epstein-Zin preferences, where the link between risk aversion and intertemporal substitution is broken, is considered With this form of preferences, slightly more sensitivity was found for high potential future (uncertain) costs and low substitution elasticities. The size of the potential future tax-financed cost and its associated probability were found to be the major determinants of the optimal policy
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a call
