Optimal Tax Policy Under Uncertainty Over Tax Revenues

This paper investigates optimal tax policy when economic conditions are uncertain, creating risk in tax revenues. Optimal taxation with uncertainty balances costs from volatility and deadweight loss. Tax policy affects volatility through two channels; spreading risk between public and private consumption and hedging idiosyncratic tax base risk. Risk in tax revenues can be decomposed into economic uncertainty and systematic and unnecessary tax policy risk. This paper develops a volatility index that measures the cost of unnecessary risk associated with a tax portfolio. Using panel data from all US states for the years 1964-2013, I find that almost all states increased their portfolio risk during this period and half of these states exposed their tax revenues to more unnecessary risk. This suggests states could reduce their tax revenue volatility by rebalancing their tax portfolios without decreasing expected tax revenues