Optimal Taxation and the Stationarity of State Tax Rates

To minimize deadweight losses, tax rates should vary unpredictably so agents cannot rearrange their work and consumption habits. As a result, optimally set tax rates will be a nonstationary time series or, put differently, changes in the tax rate will be unpredictable. This paper identifies different fiscal policy environments under which groups of states operate and tests whether these commonalities explain the behavior of states' tax rate setting behavior. Results show that only states that must balance less than 50% of their budgets or have a supermajority rule optimally set tax rates