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Debt and Budget Surpluses with a Tax Habit and Balanced Budget Hawks

Author: ELENA LOUKOIANOVA AND SHAUN P. VAHEY
Published in PFM, Vol. 6 No. 2

In this paper, we demonstrate the theoretical implications of a tax habit and balanced budget hawks on the (log) primary budget surplus. The tax habit causes the budget surplus to respond more smoothly to the expected present value of government purchases than in a tax smoothing model. Put differently, a fiscal authority with a tax habit smoothes the adjustment of taxes to “news”. Fiscal policymakers advocating contemporaneously balanced budgets, which we refer to as “balanced budget hawks”, increase the sensitivity of surpluses to current government purchases. Using UK data from 1942 to 1964, we utilize Bayesian Monte Carlo Markov Chain simulation methods to gauge the importance of habit and hawks effects.

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