the government’s expenditure program (g1, g2) is fixed in place. When taxes are lump-sum, the government’s finance department faces a trivial decision: choose any (τ1, τ2) that satisfies the government’s intertemporal budget constraint. However, when taxes are distortionary, Barro (1979) has pointed out that it would be optimal for the government to smooth taxes over time. That is, the government should choose a tax rate that balances not only the government’s intertemporal budget constraint, but balances government spending and revenue on average throughout time. This implies a relatively constant tax rate and a budget deficit/surplus that fluctuates over time (but balance out over the long-run).
By smoothing taxes in this manner, the government is in effect smoothing out (and therefore minimizing) the distortions that its taxes create over time. For example, if the government requires an extraordinarily high (but transitory) level of government purchases in one period (say, to finance a war effort), the tax smoothing argument implies that the government should finance such an expenditure by issuing bonds rather than by raising taxes to extraordinarily high levels. The tax rate should be increased slightly (to minimize distortions) and kept at this higher level until the debt is paid off.
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