Journal of Monetary Economics 25 (1990) 97-112. North-Holland zyxwvutsrqponmlkjihgfedcbaZYXWVUT SEICNIORAGE AND TAX SMOOTHING IN THE UNITED STATES 1914-1986* Bharat TREHAN Federul Reserve Bunk of San Francisco, San Francisco, CA 94105, USA Carl E. WALSH Universi~ of California, Santa Cruz, CA 95064, USA Federul Reserve Bunk of San Francisco, San Francisco, CA 94105, USA Received September 1988, tinal version received August 1989 When monetary and fiscal authorities cooperate to minimize the distortionary costs of financing an exogenous stream of government expenditures, Barro’s tax-smoothing model implies a long-run relationship between tax revenues and inflation. Previous empirical tests of this relationship are reinterpreted in light of recent work on cointegration and are shown to hold only when stochastic temporal variation in the excess burden of taxes and seigniorage is transitory in nature. A new test that holds in the presence of nonstationary disturbances is developed and applied. Annual U.S. data from the period 1914 to 1986 reject the revenue-smoothing hypothesis. 1. Introduction Theoretical models of seigniorage have generally been normative in nature, building on the initial analyses of Bailey (1956) and Friedman (1969) and the theory of optimal taxation [Diamond and Mirrlees (1971)]. Friedman showed that the optimal rate of deflation equaled the real rate of return on nomnone- tary assets. A policy of achieving this optimal deflation rate has revenue implications for the government’s budget since base money must be retired at an appropriate rate, but Friedman’s analysis assumed that the revenue re- quired to do this could be raised through lump-sum taxation of the private sector. *Any opinions expressed are those of the authors and not necessarily those of the Federal Reserve Bank of San Francisco or the Federal Reserve System. The authors would like to thank Tom Willett, seminar participants at the Claremont G;aduate School, Rice University, Texas A&M, the University of Oregon, and an anonymous referee for helpful comments on an earlier version of this paper. 0304-3932/90/$3.5001990, Elsevier Science Publishers B.V. (North-Holland)