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Economics (CMC)

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The 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 ahs emphasized planning problems where the government chooses taxes and a path for government debt to minimize the excess burden of taxes over time. Alternatively, the political business cycle models focus on the fiscal policies pursued by incumbent governments to either improve their reelection prospects or to constrain the policies that future governments in power will pursue.

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 inter-temporal 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.

The outline of the paper is as follows. Section II presents the simple linear-quadratic model of taxation and derives the inequality bounds for the volatility tests. Section III presents the calculation of the inequality bounds and discusses the results. In section IV, results from Monte Carlo simulations of the model, under a range of specifications, show the robustness of the empirical results. Section V explores both business cycle and political business cycle explanation for the excess volatility of taxes. I conclude in section VI.

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© 1993 Southern Economic Association (SEA)

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