Tax smoothing, tax tilting and fiscal sustainability in Pakistan

Abstract

Pakistan has a long history of running fiscal deficits. There are two broad considerations motivating a government to run a deficit - tax smoothing and tax tilting. Tax-smoothing behavior results in fiscal deficits because in the presence of non-lump-sum taxes, optimizing governments seek to minimize the distortionary effects of taxation by keeping tax rates smooth over time, rather than varying contemporaneously with expenditure. Even if we assume that expenditures will remain constant over time, obviating the need for tax smoothing, fiscal deficits may arise due to tax-tilting behavior if the government's discount rate differs from the effective interest rate, as then there is an incentive..