The Effects of Income Tax Rate Uncertainty in a Dynamic Setting

Abstract

Most discussion of income tax policy focuses on the expected efficiency or equity gains that could result from alterations in income tax codes. Often overlooked is the uncertainty that is generated when taxpayers anticipate a change in the tax laws. For example, over the last decade the income tax codes in the U.S. have undergone three significant revisions and, while each of these revisions was accompanied by extensive debate concerning the effects of changes in particular statutory provisions, the uncertainty generated by such rapid changes in the tax codes received little attention. It is likely that the timing of these revisions as well as the revisions themselves were difficult to predict and, consequently, contributed to the uncertainty facing taxpayers. While income tax codes may be subject to a wide variety of changes, arguably the most consequential is a change in tax rates, given a fixed tax base. With a fixed tax base, changes in statutory tax rates translate into changes in effective tax rates. Because changes in effective rates have such a pervasive influence on decision making, it seems reasonable to expect that uncertainty regarding future effective tax rates may have serious consequences. We explore the impact of this particular form of tax code uncertainty on an individual's saving and portfolio decision making in a dynamic setting. Throughout our analysis the tax base is unchanging, so that we do not bother to distinguish between effective and statutory tax rates. In this setting we assume that the timing of tax rate changes is uncertain and that, if a change occurs, the new tax rate is unpredictable. We find that more (less) risk averse taxpayers will respond to an increase in the likelihood of a change in the tax code or an increase in the variability of future tax rates by increasing (decreasing) saving. We are also able to characterize those situations in which an increase in the likelihood of a change in the tax code or an increase in the variability of future tax rates will depress risk-taking. There is a growing literature that examines the effects of income tax uncertainty. For example, Auerbach and Poterba [3] and Bernheim [4] have dealt with uncertainty that alters a firm's taxable income, and, consequently, the effective tax rate faced by the firm. Auerbach and Hines [2] have analyzed corporate investment behavior in the U.S. by taking into account the possibility that investors anticipate future changes in tax laws. Models that examine the welfare consequences of uncertain tax rates have been developed by Weiss [9] in a static setting and by Bizer and Judd [5] in a dynamic setting. Estimates of the welfare costs associated with statutory tax uncertainty in