On Dynamic Tax Reform with Regime Switching

Abstract

This article investigates the effect of tax reform from the viewpoint of regime switching and finds that, following a tax-reform announcement with constant government spending, the key factor determining the adjustment patterns of consumption and capital is the relative extent of the tax-reform-induced “substitution effect” versus the tax-reform-induced “savings-investment effect.” Furthermore, if a rise in government spending is associated with an announcement of tax-financing change, then a crowding-in, a partial crowding-out, or an over-crowding-out effect may be exhibited prior to a government financing change. At the instant of regime switching, consumption exhibits a discontinuous fall to ensure the optimality condition.