Tax smoothing with stochastic interest rates: A reassessment of Clinton's fiscal legacy

Abstract

The return to "sound" fiscal policy after the high budget deficits of the 1980s and early 1990s has been hailed by many as the Clinton administration's most important achievement. We evaluate post-war, U.S. fiscal policy using a generalized tax-smoothing model that allows for stochastic interest rates and growth rates. We show that contrary to conventional wisdom, the evolution of the U.S. debt-GDP ratio during the 1980s was remarkably consistent with the tax-smoothing paradigm. In fact, a more substantial departure occurred during the late 1990s, when the debt-GDP ratio fell more rapidly than predicted by optimal tax smoothing. Copyright 2005 by The Ohio State University.