Are state and provincial governments tax smoothing? Evidence from panel data.

• Author: Strazicich, Mark C.

1. Introduction

   The theory of debt examined here is known variously as "efficient taxation over time," "optimal taxation over time," the "equilibrium approach to fiscal policy," or "tax 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 "tax 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 "tax 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 debt. The model is primarily due to Barro [1]. The goal of this paper is to contribute to our understanding of government debt. The focus of this paper is on state and provincial debt, or what is generally referred to as "state and local debt."

   Nearly every state government in the United States has a balanced budget rule. However, balanced budget rules are not sufficient to rule out tax smoothing, as state governments could build up budget surpluses in good times to smooth budgets over the business cycle. If state governments are smoothing tax rates, then their budget surpluses are endogenous. Contrary to the state 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 state and provincial tax rates respond to current conditions, rather than seeking to minimize the costs of intertemporal tax distortions. For example, a rejection of tax smoothing by state governments, combined with balanced budget rules, suggests that state governments balance budgets annually in response to current conditions.(1) This could explain the occurrence of state budget crises during times of slow output growth and/or fast expenditure growth. A rejection of tax smoothing by provincial governments might suggest some sort of political business cycle to explain their sometimes large budget deficits, even on current expenditures.

   Empirical testing is undertaken using annual data for fifty states and ten provinces respectively. Tests are performed with panel data, created by pooling data on each state or province. The use of panel data significantly increases the power of the unit root test to reject its null hypothesis. Results clearly reject tax smoothing by state governments, but results cannot reject tax smoothing by provincial governments. Differences in resource mobility is suggested as an explanation for the differences in tax smoothing.

   Section II looks at the theory of efficient taxation over time. Section III describes the model. Section IV discusses the tax rate data. Sections V and VI present the empirical tests. Section VII summarizes the results.

2. Efficient Taxation over Time

   Tax smoothing implies that efficient governments set tax rates today to minimize the cost of intertemporal resource substitution, subject to a long-run balanced budget constraint. Given all available information, the tax rate would be considered as permanent and would not be arbitrarily changed. Only new information about the future path of government spending and output would cause governments to change the tax rate. No prediction could be made of future tax rate changes; therefore, the tax rate would behave as a random walk, and today's tax rate would be the best predictor of future tax rates.

   Empirical testing of the tax smoothing hypothesis has focused on federal governments.(2) Results of these tests have been mixed. Barro [2; 3], Kochin, Benjamin, and Meador [13], and Huang and Lin [11] find general support for tax smoothing by the U.S. federal government. Gupta [10] finds evidence supporting tax smoothing when examining the Canadian federal tax rate. Sahasakul [16], and Bizer and Durlauf [6; 7] reject tax smoothing for the U.S. federal government. Trehan and Walsh [18] reject tax smoothing when examining U.S. federal tax revenues. These tests examine either the time series properties of the tax data, or estimate regression models suggested by tax smoothing. Application of these tests to a single state or provincial government is not recommended. The time series available for a single state or province is too short to get reliable estimates. By examining panels created by pooling data from fifty states or ten provinces, the size of each sample is greatly increased, resulting in more efficient estimation and significantly increased power to reject the null hypothesis.

   Benjamin and Kochin [4; 5] suggest the ability of efficient governments to smooth tax rates may be restricted at the state and local levels. Mobility of taxable resources may prevent state and local governments from tax smoothing. As temporary deficits and surpluses occur, mobile resources could seek out jurisdictions where the current benefits of government spending exceed the current costs. This would limit the ability of efficient state and local governments to smooth tax rates and could explain the large number of balanced budget rules that exist among these governments in the U.S.

   The mobility of taxable resources is likely to be less between provinces in Canada than between states in the U.S. for a number of reasons. First, Canada's provinces are generally larger in area than most states. Second, having two official languages, with French being confined largely to Quebec, and to a lesser extent New Brunswick, mobility would be more costly for...