Absent theoretical guidance, empiricists have been forced to rely upon numerical comparative statics from constant tax rate models in formulating testable implications of trade-off theory in the context of natural experiments. We fill the theoretical void by solving in closed-form a dynamic trade-off theoretic model in which corporate taxes follow a Markov process with exogenous rate changes. We simulate ideal difference-in-differences estimations, finding that constant tax rate models offer poor guidance regarding testable implications.
While constant rate models predict large symmetric responses to rate changes, our model with stochastic tax rates predicts small, asymmetric, and often statistically insignificant responses. Even with very long regimes (one decade), under plausible parameterizations, the true underlying theory — that taxes matter — is incorrectly rejected in about half the simulated natural experiments. Moreover, tax response coefficients are actually smaller in simulated economies with larger tax-induced welfare losses.