Skip to main content
SpringerLink
Log in

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

  • Published:
Empirical Economics Aims and scope Submit manuscript

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.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2

Similar content being viewed by others

Notes

  1. Lloyd-Ellis et al. (2005) extend Barro’s model by allowing for stochastic interest rates and analyze the implications of tax smoothing for the behavior of the US debt-to-GDP ratio in the 1980s and 1990s.

  2. In this model, the tax rate has a smaller variance than a balanced budget would imply; furthermore, only if government expenditures follow a random walk, so will the tax rate.

  3. At a natural asset limit, the government can generate enough interest income from its assets in order to pay its debts at a tax rate equal to zero. At a natural debt limit, the government can raise tax revenues to pay its debt with probability one. In general, the natural debt and asset limits are hard to pin down both theoretically and empirically.

  4. A negative value for \({\underline{M}}\) represents an asset limit.

  5. For example, assuming that \({\overline{x}}=2/3\), requires setting \(\eta >3/5\).

  6. We are grateful to Mohitosh Kejriwal and George Messinis who kindly provided their respective computer codes for these tests.

  7. We are grateful to one referee for suggesting the Perron–Yabu test.

  8. Here and throughout the paper, a trend stationary process with structural breaks denotes a process which is stationary within each of the sub-periods between the breaks. In general though, a process without unit roots but with breaks is nonstationary with time-varying moments but no stochastic trends. We are grateful to the coordinating editor for this clarification.

  9. Among others, Lee and Strazicich (2003) have developed Lagrange Multiplier unit root tests which are valid in the presence of structural breaks.

  10. We computed the six unit root tests using the Gauss code developed by Josep Lluís Carrion-i-Silvestre as a companion to the Carrion-i-Silvestre et al. (2009) paper, and the Perron–Yabu test using the MATLAB code developed by Tomoyoshi Yabu as a companion to the Perron and Yabu (2009) paper. Both codes are available on Pierre Perron’s Web site.

  11. Throughout the empirical analysis, we used the level of the tax rate. We also experimented with the logarithm of the tax rate. All the results in this case were quite similar to the results reported in the paper and are available upon request.

  12. The BIC criterion is parsimonious in the lag selection, compared to other model selection criteria, but it is consistent in choosing the correct number of lags.

  13. We computed these test statistics using the Gauss computer code companion to the Bai and Carrion-i-Silvestre (2009) paper, available at the Review of Economic Studies website. We are grateful to one referee for suggesting this code to us, and to both referees for suggesting panel unit root testing.

  14. The original version of the \(\hbox {P}_{{m}}\) statistic was proposed by Choi (2001) when \(N\rightarrow \infty \).

  15. For the results in Table 8, we set \(r=2\), that is, we assumed 2 unobserved common factors in the model for the tax rates. We experimented with different values of r  but the test results were not affected.

References

  • Adler J (2006) The tax-smoothing hypothesis: evidence from Sweden, 1952–1999. Scand J Econ 108(1):81–95

    Article  Google Scholar 

  • Aiyagari SR, Marcet A, Sargent TJ, Seppälä J (2002) Optimal taxation without state-contingent debt. J Polit Econ 110(6):1220–1254

    Article  Google Scholar 

  • Allingham M (1979) Inequality and progressive taxation: an example. J Public Econ 11:273–274

    Article  Google Scholar 

  • Andrews DWK, Kim J-Y (2006) Tests for cointegration breakdown over a short time period. J Bus Econ Stat 24(4):379–394

    Article  Google Scholar 

  • Angyridis C (2009) Balanced budget versus tax smoothing in a small open economy: a welfare comparison. J Macroecon 31:438–463

    Article  Google Scholar 

  • Bai J, Carrion-i-Silvestre JL (2009) Structural changes, common stochastic trends, and unit roots in panel data. Rev Econ Stud 76:471–501

    Article  Google Scholar 

  • Barro RJ (1979) On the determination of the public debt. J Polit Econ 87(5):940–971

    Article  Google Scholar 

  • Campbell JY, Perron P (1991) Pitfalls and opportunities: what macroeconomists should know about unit roots. In: Blanchard OJ, Fisher S (eds) NBER macroeconomics annual, vol 6. The MIT Press, Cambridge

    Google Scholar 

  • Carrion-i-Silvestre JL, Kim D, Perron P (2009) GLS-based unit root tests with multiple structural breaks under both the null and alternative hypotheses. Econom Theory 25:1754–1792

    Article  Google Scholar 

  • Chari VV, Christiano L, Kehoe P (1995) Policy analysis in business cycle models. In: Cooley T (ed) Frontiers of business cycle research. Princeton University Press, Princeton

    Google Scholar 

  • Choi I (2001) Unit root tests for panel data. J Int Money Finance 20:249–272

    Article  Google Scholar 

  • Elliott G, Rothenberg JT, Stock JH (1996) Efficient tests for an autoregressive unit root. Econometrica 64:813–836

    Article  Google Scholar 

  • Ghosh AR (1995) Intertemporal tax-smoothing and the government budget surplus: Canada and the United States. J Money Credit Bank 27(4):1033–1045

    Article  Google Scholar 

  • Kejriwal M, Perron P (2010) A sequential procedure to determine the number of breaks in trend with an integrated or stationary noise component. J Time Ser Anal 31:305–328

    Article  Google Scholar 

  • Lee J, Strazicich MC (2003) Minimum LM unit root test with two structural breaks. Rev Econ Stat 85(4):1082–1089

    Article  Google Scholar 

  • Lloyd-Ellis H, Zhan S, Zhu X (2005) Tax smoothing with stochastic interest rates: a reassessment of Clinton’s fiscal legacy. J Money Credit Bank 37(4):699–724

    Article  Google Scholar 

  • Lucas RE, Stokey NL (1983) Optimal fiscal and monetary policy in an economy without capital. J Monet Econ 12:55–93

    Article  Google Scholar 

  • Maddala GS, Kim I-M (1998) Unit roots, cointegration and structural change. Cambridge University Press, Cambridge

    Google Scholar 

  • Maddala GS, Wu S (1999) A comparative study of unit root tests with panel data and a new simple test. Oxf Bull Econ Stat (Spec Issue) 61:631–652

    Article  Google Scholar 

  • Ng S, Perron P (2001) Lag length selection and the construction of unit root tests with good size and power. Econometrica 69:1519–1554

    Article  Google Scholar 

  • Olekalns N (1997) Australian evidence on tax smoothing and the optimal budget surplus. Econ Rec 73(222):248–257

    Article  Google Scholar 

  • Perron P (1989) The great crash, the oil price shock, and the unit root hypothesis. Econometrica 57(6):1361–1401

    Article  Google Scholar 

  • Perron P (2006) Dealing with structural breaks. In: Patterson K, Mills TC (eds) Palgrave handbook of econometrics, volume 1: econometric theory. Palgrave Macmillan, London, pp 278–352

    Google Scholar 

  • Perron P, Ng S (1996) Useful modifications to some unit root tests with dependent errors and their local asymptotic properties. Rev Econ Stud 63:435–463

    Article  Google Scholar 

  • Perron P, Rodríguez GH (2003) GLS detrending, efficient unit root tests and structural change. J Econom 115:1–27

    Article  Google Scholar 

  • Perron P, Yabu T (2009) Testing for shifts in trend with an integrated or stationary noise component. J Bus Econ Stat 27(3):369–396

    Article  Google Scholar 

  • Pesaran HM (2012) On the interpretation of panel unit root tests. Econ Lett 116(3):545–546

    Article  Google Scholar 

  • Reitschuler G (2010) Fiscal policy and optimal taxation: evidence from a tax smoothing exercise. Scott J Polit Econ 57(2):238–252

    Article  Google Scholar 

  • Serletis A, Schorn RG (1999) International evidence on the tax- and revenue-smoothing hypotheses. Oxf Econ Pap 51:387–396

    Article  Google Scholar 

  • Shiller RJ, Perron P (1985) Testing the random walk hypothesis: power versus frequency of observation. Econ Lett 18:381–386

    Article  Google Scholar 

  • Stock JH (1990) A class of tests for integration and cointegration. In: Cointegration, causality, and forecasting: a festschrift for Clive W.J. Granger. Oxford University Press, Oxford, pp 65–119 (1999)

  • Strazicich MC (2002) International evidence of tax smoothing in a panel of industrial countries. Appl Econ 34:2325–2331

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Department of Economics, Ryerson University, 350 Victoria Street, Toronto, ON, M5B 2K3, Canada

    Constantine Angyridis & Leo Michelis

Authors
  1. Constantine Angyridis
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Leo Michelis
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Constantine Angyridis.

Ethics declarations

Conflict of interest

The authors declare that they have no conflict of interests.

Ethical approval

This article does not contain any studies with human participants or animals performed by any of the authors.

Additional information

Publisher's Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

We would like to thank the Coordinating Editor, Robert M. Kunst, and two anonymous referees for their valuable comments and suggestions which helped to improve the paper significantly. All remaining errors are our own.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Angyridis, C., Michelis, L. Structural breaks, debt limits and the tax smoothing hypothesis: theory and evidence from the OECD countries. Empir Econ 60, 1283–1307 (2021). https://doi.org/10.1007/s00181-019-01786-2

Download citation

  • Received:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s00181-019-01786-2

Keywords

JEL Classification

Search

Navigation