Tax Smoothening

• Taxes are important source of government revenue.

• In order to increase the revenue of the government to meet
the growing needs of the economy, an increase in taxes is
suggested as it is generally stated that as economy grows,
people's ability to pay taxes also increases.
• However, this bland interpretation of increase in revenue by
increasing the tax rate ignores the psychological aspect of the
income earners who always try to save tax as much as
possible and by any means.
• Such tax evasions leads to distortions in the tax system and
its ability to generate additional revenue for the government.
• The higher is the tax rate, higher will be the distortions in
collection of taxes
• In order to curb the tax evasions and generate more of the
revenue, the gvernment has to expand its administrative set
up as well, leading to an increase in administrative cost.
Alternatively, it has to bear the loss of revenue if the
government machinery fails to curb the tax evasions
• Thus, in either case that the tax distortions have some
distortion costs
Like a household who wants to maximise its utility from consumption
with its limited resources, the government, too, tries to maximise its
utility function by minimisin the distortion costs. So, it tries to set that
tax rate at which the total distortions will be minimum. It is called 'Tax
Smoothening'. We can analyse it under two heads-
1. Tax Smoothening under Cerainity
2. Tax Smootheining under Uncertainity
1. Tax Smoothening Under Certainity: Under the conditions of
certainity, it is easier to chose a tax rate that can meet the government
expenditure without much distortions. Under this, the governments
can easiliy estimate the costs and benefits of increasing or reducing a
tax rate at any point of time in future as the behaviour of the tax
payers is predictable.
If we take 'Y' as output, 'G' as government purchases, 'r' the real rate
of interest, D(o) as the initial debt of the government and the
government aims at chosing a tax rate which not only satisfies its
budget constraint but also minimise the distortion costs that the taxes
may create. In this context it builds its objective function to minimise
the distortion cost subject to the constraint that its expenditure as well
the initial debt is covered by the revenue generated.
So, before looking at the objective function of the government, it is important to
see the distortion costs of the taxes. As discussed earlier, the distortions costs are
the direct function of the tax rate. The tax rate is defined as the ratio of taxes to
income i.e. Tt/Yt It has been shown below:

f()  0 
T 
Ct  Yt . f  t  where,f ()  0 
 Yt  f ()  0
Here, f(o) = 0 means that if there is no tax, there will be no distortion cost;
f'(0)>0 means any increase in taxe rate leads to a positive distortion
cost ;and
f''(0)>0 means that the distortion cost increases with an increase in tax rate.
Now the objective function of the government is to minimise this cost,
subject to the constraint that it can generate enough revenue to meet its
expenditure needs, hence,

1  Tt 
min . .Yt . f  
t  0 (1  r )
t
 Yt 
 
1 1
subject to the constraint that  .Tt  D0   .Gt
t  0 (1  r ) t  0 (1  r )
t t
Let us take the case that the government reduces taxes by ∆T in 't' time period and
tries to increase the taxes by (1+r) ∆ T in the next time period. People will enjoy
some benefits in time period 't' due to reduction in tax rate but will feal the pinch in
the next time period when the tax rate is increased. But they will be indifferent or
will not involve in activities of tax evasion if their marginal benefits from the
reduction in tax rate is just equat to their marginal cost due to increase in tax rate in
the next period. The functions of marginal benefits (MB) and marginal cost (MC)
are given below:
1  Tt  1
MB  .Yt . f  . .(T )

(1  r ) t
 Yt  Yt
1  Tt 
 . f  .T
(1  r ) t
 Yt 
and the cost function is
1  Tt 1  1
MC  t 1
.Yt 1 . f  . .(1  r ). T
(1  r )  Yt 1  Yt 1
after cancelling (1  r) and Yt 1 in numerator and the denominato r,
we get
1  Tt 1 
MC  . f 
 . T
(1  r ) t
 Yt 1 
Taking MB = MC, we have

1  Tt  1  Tt 1 
 
. f  . T  . f 
 . T
(1  r ) t
 Yt  (1  r ) t
 Yt 1 
 Tt   Tt 1 
f    f  
 Yt   Yt 1 
This requires
 Tt   Tt 1 
    
 Yt   Yt 1 
it shows that to minimise the distortion cost, the tax rate in 't' time period
should remain equal to the tax rate in (t+1) time period. Keeping the tax rate
same in two different time periods, in order to avoid the distortion cost is called
'Tax Smoothening'
 Tax Smoothening Under Uncertainity
When the things are uncertain about the income of the people, their capacity to pay
and also under uncertain economic conditions, there will be a need to make the
rational expectations about the distortions as well as the expected tax rates and
expected government expenditure. In this case while budget constraint is the same,
the objective function is to minimise the expected present value of the distortion
cost, hence
 T    T 
f 
 t
  E t  f 
 t  1
 
 Y t    Y t  1 
  T 
 E t  f   t  1
 
  Y t  1 
This requires
 T   T 
 t
  E t
 t  1

 Y t   Y t  1 

Thus, here too, we can see that the distortion cost is minimised if the tax rate is kept
similar in two time periods