Testing the Positive Theory of Government Finance

Researchers characterizing optimal tax policies for dynamic economies have reasoned that optimally chosen tax rates should approximately follow a random walk. We conduct a frequency-domain examination of the properties of the tax rate series and conclude that while there is a substantial smoothing role for debt, one rejects the hypothesis that the first difference in the series is white noise. This conclusion follows both from an analysis of the entire spectral distribution function of tax changes as well as from the behavior of individual frequencies. The source of the rejection is pronounced activity of tax changes at an eight year cycle which is suggestive of an electoral component to tax changes. Regression analysis confirms the finding that there is a cyclical component to tax changes corresponding to changes in political party administration. The results suggest that the positive theory of government finance needs to be refined to incorporate features of political equilibrium.