The Perils of Tax Smoothing: Sustainable Fiscal Policy with Random Shocks to Permanent Output
IMF Working Papers, November 1, 2005
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Bibliographic details
- Authors: Evan C Tanner, Kevin J Carey
- Published: November 1, 2005
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451862263.001
Summary and central finding
- If permanent output is uncertain, tax smoothing can be perilous: both debt levels and tax rates are difficult to stabilize and may drift upwards.
- Alternative policy instruments may be required to achieve sustainable fiscal outcomes under random shocks to permanent output.
Key findings from the paper
- Tax smoothing alone:
- Can lead to upward drift in both debt levels and tax rates when permanent output is uncertain.
- Makes stabilizing debt and tax rates difficult under stochastic shifts in long-run output.
- Debt-targeting as a remedy:
- Targeting the debt is a practical remedy to the perils of tax smoothing.
- Simulations confirm that debt-targeting would require undesirably volatile fiscal adjustments.
- Debt-targeting may inhibit countercyclical borrowing.
- Linking primary surplus to volatility:
- An alternative policy is to link the primary surplus not only to the debt ratio (as under tax smoothing) but also to its volatility.
- This approach can preempt further adjustments and gradually reduce the debt.
Policy implications and recommendations
- Avoid sole reliance on tax smoothing when permanent output is uncertain because it can produce undesirable drifting outcomes for debt and tax rates.
- Consider explicit debt-targeting, recognizing tradeoffs:
- Debt-targeting can stabilize debt but at the cost of high fiscal adjustment volatility and reduced scope for countercyclical borrowing.
- Develop fiscal rules or primary surplus rules that:
- Link the primary surplus to both the debt ratio and the volatility of the debt ratio.
- Aim to preempt further fiscal adjustments while gradually reducing debt over time.
Methodology and scope
- The paper uses simulations to evaluate policy responses to random shocks to permanent output.
- Subject areas listed: Expenditure, Fiscal policy, Public debt, Tax arrears management, Vector autoregression.
- Keywords listed: debt ratio, objective function, standard deviation, WP.