Rules Versus Discretion in Tax Policy

The current fiscal climate is predicated on the notion that revisions to the tax code would be forthcoming every four years, i.e., corresponding to the presidential election cycle. While the depth of the adjustments is usually unknown, the probability that adjustments will happen is substantial. Yet it is the depth and the direction of the adjustment that has real effects. Businesses, large and small, fa ce a burden; but as has been documented by previous research, small businesses bear a disproportionate share of the burden imposed by all federal regulations, including tax regulations. Small business associations identify taxes as the single most important issue facing small businesses. Unexpected shifts in the tax rate and structure only exacerbate the already difficult circumstances involved in running a small business. Now in addition to the uncertainties inherent in operating a small business, business owners must make allowances for unknown changes in the tax code while making plans that extend beyond the next presidential election cycle. There is an inherent problem here that, when explicitly stated, can be quite worrisome: the time horizon that a small business adopts when making plans is longer than the certainty period afforded by the election cycle. Therefore, every possible outcome would be less than optimal. The advantages of a policy- making system based on rules rather than discretion have long been debated in the economics literature. Kydland and Prescott (1977) formalized the debate as it applies to macroeconomic policy. Their work and the literature that it generated has led to formal propositions favoring rules that constrain changes in monetary policy. The present paper extends the analysis in the rules-versus-discretion literature to evaluate the proper role of rules in tax policy. Unexpected tax rates, a consequence of discretionary tax policy, are detrimental to the sustainability of economic progress. An empirical investigation of the effects of unexpected tax rates in the American states supports the theoretical findings. Explicitly agreed upon rules limit the range within which tax rates can vary, and consequently restrict their volatility. With uncertainty reduced over a sufficiently long time horizon, optimal plans can be implemented at both the public and private levels.