1.

A smooth tax rate minimizes distortion costs - analyze the statement using barro’s tax
smoothing model. (7.5) - 2018, 2016 According to the tax smoothing model of Barro, explain
what determines the budget deficit. (10) 2011
2. Short note - tax smoothing under certainty (5) 2013
3. What does barro’s tax smoothing model mainly focus on? Examine the behavior of deficits
using the barrows tax smoothing model under uncertainty. (10) - 2012
4. What is the main idea of Barro’s tax smoothing model? Using this model, show that: 2013
a) Under certainty, tax rate must be constant (6)
b) Under uncertainty, tax rate follows a random walk (6.5)

(Notes) Tax smoothing model: Tax revenue is one source of government earning, but govt doesnt
always raise taxes if there’s a deficit. If expenditure>govt revenue, that is when there is a deficit, govt
may immediately increase taxes to increase revenue, but increase in the tax rate causes behavioral
distortion in consumer/producer. Govt’s objective is to minimize the distortion associated with tax rise
keeping the expenditure and revenue balanced. Having a smooth tax rate is better than a variable tax
rate because higher variability causes more distortion.

(Mankiw) Tax Smoothing A budget deficit or surplus can be used to reduce the distortion of
incentives caused by the tax system. High tax rates impose a cost on society by discouraging
economic activity. A tax on labor earnings, for instance, reduces the incentive that people have to
work long hours. Because this disincentive becomes particularly large at very high tax rates, the total
social cost of taxes is minimized by keeping tax rates relatively stable rather than making them high in
some years and low in others. Economists call this policy tax smoothing. To keep tax rates smooth, a
deficit is necessary in years of unusually low income (recessions) or unusually high expenditure
(wars).

(Romer) The basic idea of the tax-smoothing model of deficits is that since taxes distort individuals’
choices and since those distortions rise more than proportionally with the tax rate, steady moderate tax
rates are preferable to alternating periods of high and low tax rates.

Limitation: Tax-smoothing does not appear to be consistent with large persistent deficits or for the
pursuit of fiscal policies that are unlikely to be sustainable. There may be a systematic tendency for
the political process to produce excessive deficits.

​Barro (1979) focuses on the government’s desire to minimize the distortions associated with
obtaining revenue. Taxes are not a lump sum, but rather a function of income, thus they distort
behavior and so cause inefficiencies. The distortions created by taxes are likely to increase more than
proportionally with the amount of revenue raised. For low taxes, the distortion costs are approximately
proportional to the square of the amount of revenue raised. When distortions rise more than
proportionally with taxes, they are on average higher under a policy of variable taxes than under one
with steady taxes at the same average level. Thus the desire to minimize distortions provides a reason
for the government to smooth the path of taxes over time.

Govt wants to choose a smooth path for taxes by minimizing PV of distortion costs due to taxes
subject to maintaining a minimum level of revenue / satisfying its overall budget constraint.
Tax-Smoothing under Certainty
Consider a discrete-time economy. Output (Y), government purchases (G), and the real interest rate
(r) are exogenously given and certain. For simplicity, the real interest rate is constant. There is some
initial stock of outstanding government debt, D0. The government wants to choose the path of taxes
(T) to satisfy its budget constraint while minimizing the present value of the costs of the distortions
that the taxes create. We assume that the distortion costs from raising amount T t are given by:

where Ct is the cost of the distortions in period t associated with the function of taxes relative to
output, and that they rise more than proportionally.

Govt faces the problem:

There are two ways to solve this - using constrained optimization using the Lagrangian function or
Euler approach. We will use the Euler approach.

Consider the government reducing taxes in period t by a small amount ΔT and increasing taxes in the
next period by (1 + r )ΔT, with taxes in all other periods unchanged. This change does not affect the
present value of its revenues. Thus if the government was initially satisfying its budget constraint, it
continues to satisfy it after the change. And if the government’s initial policy was optimal, the
marginal impact of the change on its objective function must be zero. That is, the marginal benefit and
marginal cost of the change must be equal.

The benefit of the change is that it reduces distortions in period t. Specifically, equation (12.13)
implies that the marginal reduction in the present value of distortions, MB, is

The cost of the change is that it increases distortion in t + 1. From (12.13) and the fact that taxes in
period t + 1 rise by (1+ r )ΔT, the marginal increase in the present value of distortions, MC, is
Comparing (12.14) and (12.15) shows that the condition for MB=MC

That is, taxes as a share of output (the tax rate) must be constant. With increasing marginal
distortion costs from higher taxes, smooth taxes minimize distortion costs. More precisely,
because the marginal distortion cost per unit of revenue raised is increasing in the tax rate, a smooth
tax rate minimizes distortion costs.

Tax-Smoothing under Uncertainty

Under conditions of uncertainty, the government’s problem is to minimize the expected present value
of the distortions from raising revenue. Its budget constraint is the present value of tax revenues must
equal initial debt plus the present value of purchases.

We can use the Euler approach in this case. Given its information in those periods, consider the
government reducing taxes in period t by a small amount ΔT and to continue to satisfy its budget
constraint, it increases taxes in period t + 1 by (1 + r )ΔT. If the government is optimizing, the change
in taxes does not affect the expected present value of distortions.

Et[•] denotes expectations given the information available in period t. This condition states that there
cannot be predictable changes in the marginal distortion costs of obtaining revenue.

When the distortion costs, f (•), are

quadratic, f′(•) is linear.

Thus, Et[f′(Tt+1/ Y t +1)] = f ′(Et [Tt +1/Yt +1]).

Equation (12.18) becomes

which requires

This equation states that there cannot be predictable changes in the tax rate. That is, the tax rate
follows a random walk.
Implications of Barro Tax Smoothing Model:
If government purchases as a share of output are a random walk, there will be no deficits: when
purchases are a random walk, a balanced-budget policy causes the tax rate to follow a random walk.
Thus the model implies that deficits and surpluses arise when the ratio of government purchases to
output is expected to change.

We can predict movements in the purchases-to-output ratio during wars and recessions. Military
purchases are usually temporarily high during wars. Similarly, government purchases are roughly
acyclical, and are thus likely to be temporarily high relative to outputs in recessions. These are times
when the expected future ratio of government purchases to output is less than the current ratio.
Consistent with the tax-smoothing model, we observe that governments usually run deficits during
these times.