Tuesday, July 26, 2005
A long line of literature argues that income taxes do not tax the return to risk bearing. The conclusion, if correct, has important implications for the choice between an income tax and a consumption tax and for the design of income taxes. The literature, however, on its face seems unrealistic because it models only very simplified tax systems, assumes perfect rationality by individuals, and requires the government to take complex positions in securities markets to hold in equilibrium. This paper examines the extent to which these problems affect the conclusions we draw from the literature. It argues that the criticisms are overstated. Moreover, the criticisms do not detract from the central value of the models, which is to understand ideal income taxes, which are the purported goal of most who support an income tax.