A simple optimal taxation theory is used to assess whether tax rates fluctuate excessively, and the results indicate that there has been too much volatility in tax rates, despite government spending having been relatively smooth. Political business cycles should be born in mind when building models of tax changes, and there is a link between higher taxes and whther or not presidents are returned to power. There also appears to be a cycle lasting eight years underlying tax changes.
Are tax rates too volatile?
I. IntroductionThe way in which a government chooses to raise tax revenue over time has attracted considerable attention both in the tax literature, and the political business cycle literature. The tax literature has emphasized planning problems where the government chooses taxes and a path for government debt to minimize the excess burden of taxes over time (see Barro [21 and Lucas and Stokey ). Alternatively, political business cycle models focus on the fiscal policies pursued by incumbent government to either improve their reelection prospects or to constrain the policies that future government in power will pursue (see Alesina and Tabellini , Hess , Persson and Svensson , Rogoff and Sibert ). This paper addresses the question of whether tax rates fluctuate "in excess" of movements in economic fundamentals. I consider, below, a simple theory of optimal taxation which implies that tax rates should follow a random walk. Under this null hypothesis, variance bounds on the intertemporal government budget constraint are derived. The methodology of evaluating these variance bounds corresponds to the stock market volatility literature pioneered by Leroy and Porter  and Shiller . Using the methodology of Mankiw, Romer and Shapiro (hereafter M-R-S) [16; 17], these bounds are calculated for United States data from 1870-1989. There are two main benefits to using the M-R-S methodology. First, it uses non-central rather than central variances which eliminates the bias due to estimating the sample means. Second, the M-R-S methodology allows the forcing variables (government expenditures and seignorage) to be potentially non-stationary series. The inability of earlier volatility tests literature to allow for non-stationarity in the forcing variables was a considerable drawback. It is found that broad movements in tax rates that correspond to relatively large permanent changes in government expenditures are adequately "smoothed". However, it appears that tax rates have been excessively volatile in the United States both in the time period before World War I and after World W...