Taxation and Uncertainty

Abstract

While taxes may be certain, U.S. tax policy has certainly not been. Furthermore, intrinsic economic risk makes investment decisions risky. Therefore, a serious examination of the effects of tax policy on dynamic economic behavior should consider both sources of uncertainty. This paper presents a simple theoretical and computational model that can analyze both intrinsic risk and uncertain taxation. Furthermore, it will be clear that these techniques will be useful for examining general problems of taxation and risk. When studying the impact of past and/or proposed tax changes, one of two extreme assumptions are usually made: either agents are perfectly aware of future tax policy, a perfect foresight assumption, or they always believe that no change will ever occur, a myopic foresight assumption. These two assumptions yield substantially different views of recent tax experience, as Alan Auerbach and James Hines (1987) demonstrate in a partial-equilibrium context. Both are clearly wrong. The myopic specification assumes that individuals believe at each point in time that the current tax law will surely continue forever, even after they have been hit repeatedly with tax changes. On the other hand, it is absurd to think that in, say, 1977, a significant number of individuals perfectly knew the various tax changes that would occur during the following decade. This paper analyzes a dynamic general equilibrium model wherein taxpayers understand the uncertainty in tax policy when making their deci-