Fiscal Foresight: Analytical Issues

Fiscal foresight—the phenomenon that legislative and implementation lags ensure that private agents know the tax rates they face in the future—is intrinsic to the tax policy process. Although acknowledged in empirical work, theoretical analysis of its implications is scant. This paper develops an analytical framework to study the econometric implications of fiscal foresight. A simple example shows that foresight produces equilibrium time series with a non-invertible moving average component, which misaligns the agents’ and the econometrician’s information sets in estimated VARs. Economically meaningful shocks to taxes, therefore, cannot be easily extracted from statistical innovations. Noninvertibility arises as a natural outgrowth of the fact that optimal decisions discount future tax obligations; non-invertibility, therefore, is likely to be endemic to the study of fiscal policy.