Rules Versus Discretion in Tax Policy

Posted: 1 Dec 2009

See all articles by Radwan Saade

Radwan Saade

Government of the United States of America - Office of Advocacy

Date Written: 2002


The current fiscal climate is predicated on the notionthat revisions to the tax code would be forthcoming every four years, i.e.,corresponding to the presidential election cycle. While the depth of theadjustments is usually unknown, the probability that adjustments will happen issubstantial. Yet it is the depth and the direction of the adjustments that hasreal effects. Businesses, large and small, face a burden; but as has been documented byprevious research, small businesses bear a disproportionate share of the burdenimposed by all federal regulations, including tax regulations. Small businessassociations identify taxes as the single most important issue facing smallbusinesses. Unexpected shifts in the tax rate and structure only exacerbate thealready difficult circumstances involved with running a small business. Now in addition to the uncertainties inherent in operating a small business,business owners must make allowances for unknown changes in the tax code whilemaking plans that extend beyond the next presidential election cycle. There isan inherent problem here that, when explicitly stated, can be quite worrisome:the time horizon that a small business adopts when making plans is longer thanthe certainty period afforded by the election cycle. Therefore, every possible outcome would be less than optimal. The advantagesof a policy-making system based on rules rather than discretion have long beendebated in the economics literature. Kydland and Prescott (1977) formalized thedebate as it applies to macroeconomic policy. Their work and the literaturethat it generated has led to formal propositions favoring rules that constrainchanges in monetary policy. The present paper extends the analysis in the rules-versus-discretionliterature to evaluate the proper role of rules in tax policy. Unexpected taxrates, a consequence of discretionary tax policy, are detrimental to thesustainability of economic progress. An empirical investigation of the effectsof unexpected tax rates in the American states supports the theoreticalfindings. Explicitly agreed upon rules limit the range within which taxrates can vary, and consequently restrict their volatility. With uncertaintyreduced over a sufficiently long time horizon, optimal plans can be implementedat both the public and private levels. (Publication abstract)

Keywords: Tax rates, Federal regulations, Financial policies, Regulations, Public policies, Tax policies

Suggested Citation

Saade, Radwan, Rules Versus Discretion in Tax Policy (2002). University of Illinois at Urbana-Champaign's Academy for Entrepreneurial Leadership Historical Research Reference in Entrepreneurship, Available at SSRN:

Radwan Saade (Contact Author)

Government of the United States of America - Office of Advocacy ( email )

409 Third St., S.W.
Washington, DC
United States

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