Parameter Instability, Expectations, Exogenous Fiscal Shocks, and the Relationship between Taxes and Government Spending

Abstract

This dissertation focuses on the US government spending and taxes relationship. Chapter 2 considers the empirical relationship of taxes and spending using Granger causality test robust to parameter instability. The results show that revenues cause expenditures and expenditures cause revenues, as the fiscal synchronization suggests, only after taking into account parameter instability, using Rossi's (2005) test. Chapter 3 considers impulse response functions to see whether decreases in newly and already legislated taxes decrease government spending, as the "starve the beast" hypothesis suggests. Results show that these two shocks affect government spending in different ways. News about future tax cuts decrease government spending before these cuts are implemented, supporting the "starve the beast" hypothesis. Likewise, newly legislated tax cuts create a fiscal illusion, leading voters to demand higher government spending. Finally, Chapter 4 examines the behavior of the average tax rates following the present value of government war spending changes. Using impulse response functions, the point estimates suggest that a spending increase of 1% of GDP increases the average tax rate 0.2% on average, supporting the tax smoothing idea.