Empirics on Fiscal Smoothing: Some Econometric Evidence for the Indian Economy

Fiscal smoothing plays an important role in macroeconomic policies and it implies that the fiscal behavior in an economy is sustainable under unchanged fiscal policies. Fiscal smoothing includes both tax smoothing and revenue smoothing in an economy. Optimal collection of taxes has been an area of interest. Assuming that the taxes are distorting, Barro (J Polit Econ 87:940–971, 1979) propounded the tax-smoothing hypothesis which suggests that tax rates should be smoothed over time using a dynamic optimal control problem to be solved by the government. Employing similar framework, Mankiw (J Mon Econ 200:327–341, 1987) derived the revenue-smoothing hypothesis as a part of positive theory of monetary and fiscal policy. The underlying basic principle is that an increase in government revenue requires the use of both fiscal and monetary policies. Several attempts have been made in the past to test the tax-smoothing hypothesis at the national and subnational levels. Using the contemporaneous single equation ordinary least squares (OLS), Mankiw (J Mon Econ 200:327–341, 1987) and Poterba and Rotemberg (J Money Credit Bank 22:1–18, 1990) find a support for the revenue-smoothing hypothesis. Employing more advanced theory of econometric analysis of time series, Trehan and Walsh (J Mon Econ 25:97–112, 1990), Froyen and Waud (J Macroecon 17:111–129, 1995), Ghosh (J Money Credit Bank 27:1033–1045, 1995), and Evans and Amey (J Macroecon 18:111–125, 1996) generally reject the revenue smoothing. Tax-smoothing hypothesis is generally supported for the federal governments and rejected for the state and local levels (Strazicich, J Macroecon 19:305–326, 1997). In the present chapter, an attempt is made to test both tax-smoothing hypothesis and revenue-smoothing hypothesis for central and state taxes for the Indian economy implying that the tax rates are a martingale. This chapter tests a version of Barro’s tax-smoothing model and Mankiw’s revenue-smoothing hypothesis using the Indian data for 1970–1971 and 2000–2001, respectively. We use the OLS method of estimation to test the revenue-smoothing hypothesis and unit root tests based on the single equation approach in which the tax rate is treated as predetermined. Analysis of the time series characteristics of tax-tilting behavior indicates that fiscal behavior in India is consistent with tax smoothing. The analysis is organized as follows. Section 2 reviews the tax-smoothing and revenue-smoothing models and presents their testable theoretical propositions. Section 3 reports the empirical results followed by Sect. 4 concluding the chapter.