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Tax Base Variability and Procyclical Fiscal Policy

  • Ernesto Talvi
  • Carlos A. Vegh

Based on a sample of 56 countries, we find that while fiscal policy in the G-7 countries appears to be broadly consistent with Barro's tax smoothing proposition, in developing countries government spending and taxes are highly procyclical (i.e., government spending rises and taxes fall during expansions, while the reverse is true in recessions). To explain this puzzle, we develop an optimal fiscal policy model in which running budget surpluses is costly because they create pressures to increase public spending. Given this distortion, a government that faces large (and perfectly anticipated) fluctuations in the tax base will find it optimal to run a procyclical fiscal policy. We argue that the differences in fiscal policy between the G-7 countries and developing countries can be traced back to the fact that the tax base is much more volatile in developing countries than in the G-7 countries.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7499.

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Date of creation: Jan 2000
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Publication status: published as Talvi, Ernesto and Carlos A. Vegh. "Tax Base Variability And Procyclical Fiscal Policy In Developing Countries," Journal of Development Economics, 2005, v78(1,Oct), 156-190.
Handle: RePEc:nbr:nberwo:7499
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  1. Andres Velasco, 1999. "A Model of Endogenous Fiscal Deficits and Delayed Fiscal Reforms," NBER Chapters, in: Fiscal Institutions and Fiscal Performance, pages 37-58 National Bureau of Economic Research, Inc.
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