Regime-switching debt and taxation$

The effects of changes to the tax rate are studied within a framework where an estimated regime-switching process for the debt-output ratio is embedded in a standard growth model. The regime is a hidden state variable, so agents face a signal extraction problem. Consequently, agents incorporate the possibility of switching to different fiscal regimes when forming expectations over future taxes. Decision rules have additional nonlinearity relative to fixed-regime models. Income allocation and the tax elasticity of investment depend on agents’ inference regarding the regime. Specifically, the tax elasticity can be either positive or negative, depending on whether agents perceive a tax reform as an intra-regime shock or change in regime. r 2004 Elsevier B.V. All rights reserved.