Taxation, uncertainty and the choice of a consumption tax base

Abstract

Several observers have concluded that the equivalence between the cash flow and wage tax approaches to direct consumption taxation breaks down in the presence of uncertainty, as individuals with extraordinarily large gains are treated too generously under the latter approach. In particular, Ahsan ( Journal of Public Economics, 1989, 40, 99–134; Canadian Journal of Economics, 1990, 23, 408–433) contends that equivalence obtains only if returns in excess of a safe rate of return are included in the wage tax base. This paper constructs an alternative and arguably more plausible model under which full equivalence between the two approaches obtains even in the presence of uncertainty. It also derives Ahsan's result in a more general context, and demonstrates that the divergence between the two analyses is attributable to different assumptions regarding the cost to the government of an uncertain revenue stream.