...Atkinson-Stiglitz for a Uniform Commodity Tax II. THE CASE FOR (AND AGAINST) INCOME AVERAGING A. Annual Versus Lifetime Systems B. The Permanent Income Hypothesis C. The Case for Income Averaging Under the Permanent Income Hypothesis 1. Distribution 2. Efficiency D. Implementing Income Averaging E. Problems with the Case for Income Averaging 1. Incomplete markets a. "Great expectations" b. Risk c. Inability to annuitize 2. Departures from consistent rational choice a. Hyperbolic discounting and other causes of myopia b. Mental accounts 3. Additional information a. Past earnings b. Savings c. Age-related wage distribution and labor supply elasticity F. Conclusions Regarding Income Averaging III. IMPLICATIONS FOR THE CHOICE BETWEEN INCOME AND CONSUMPTION TAXATION A. Overlap Between the Cases for Income Averaging and for Consumption Taxation B. The Distributional Case for Consumption Taxation Under the Permanent Income Hypothesis C. The Efficiency Case for Consumption Taxation Under the Permanent Income Hypothesis D. Problems with the Case for Consumption Taxation 1. Incomplete markets 2. Departures from consistent rational choice 3. Additional information E. Conclusions Regarding Consumption Taxation CONCLUSION

INTRODUCTION

For many decades in United States tax policy debate, fundamental tax reform was identified primarily with adopting a comprehensive income tax base. (1) In the last ten or so years, it has increasingly come to denote instead replacing the income tax with a consumption tax. (2) This shift has been as unmistakable in the academic literature as in public political debate. (3) Its occurrence is important, even though in my view the prospects for fundamental reform are decidedly dim, (4) because ideas and ideals matter.

In academic circles, the shift reflects an emerging new consensus (widespread if not universal) that an ideal consumption tax is unambiguously superior to an ideal income tax, (5) taking into account concerns of both efficiency and distribution. This view rejects any tradeoff between the two types of ideal tax bases, such as between greater progressivity and greater efficiency, (6) or between different kinds of efficiency. (7) Rather, the ideal consumption tax is viewed as capable of being equally progressive but more efficient, or equally efficient but more progressive, causing it to dominate the ideal income tax in any comparison. (8)

There is something mystifying about this shift in ideals, no matter how intellectually persuasive one finds it. Consider a second possible shift in normative framework, from favoring an annual income or consumption tax to favoring one that is lifetime-based. Under a lifetime-based system, even if tax payments are remitted annually, lifetime rather than merely annual economic results determine how much one must pay. Thus, people with fluctuating incomes do not end up paying more tax than those with stable incomes, as happens under an annual system with graduated marginal rates. A lifetime-based system that still employs annual tax returns can be implemented through income averaging, a system that the economist William Vickrey proposed nearly seventy years ago (9) and that the U.S. federal income tax featured in a much more limited fashion from 1964 through 1986. (10) Income averaging has received extensive, but on the whole surprisingly unfavorable, attention in the tax policy literature, (11) even though the intellectual case for it substantially overlaps with that underlying the new pro-consumption tax consensus. At the level of ideals, leaving aside differences in administrative feasibility, it makes little sense to accept one idea while viewing the other so skeptically.

The reason for the overlap is that the case for a consumption tax, no less than that for income averaging, relies on taking a lifetime, rather than a current-year or snapshot, perspective in evaluating individuals' welfare and in predicting their behavior. A simple example can help to demonstrate this intuitively. Suppose that, in a given year, Xavier and Yolanda each spend their entire $100,000 salaries on consumption, and thus are treated the same by a consumption tax even though Xavier has a million dollars in the bank while Yolanda has no savings. How can this be justified, when Xavier is obviously so much better-off? The answer, from a consumption tax standpoint, is that Xavier does indeed bear a much higher tax burden, because in the long run he will be taxed just as heavily, as if he had spent the million dollars, on top of the $100,000, this year. (12) This argument, however, requires taking a lifetime rather than a merely annual perspective--and indeed, perhaps, a longer than single-life perspective if Xavier leaves money to his heirs--raising, as we will see, the very same issues as the case for income averaging.

The persistence of the peculiar disjuncture between the income versus consumption tax debate and the income averaging debate reflects under-appreciation both of the affirmative case for income averaging and of its relationship to the case for a consumption tax. In addition, while consumption taxation certainly does not lack critics, its reliance on the same long-term perspective as income averaging remains under-appreciated. However, this reliance on a long-term perspective makes the cases both for income averaging and for consumption taxation depend on the accuracy of the assumptions needed to support the use of such a perspective. In particular, such reliance rests on three critical assumptions, each of which is subject to challenge.

1) Complete markets. Markets are complete when they cover every possible commodity and combination thereof. (13) In illustration, with complete labor markets one can work at one's wage rate for any number of hours between zero and full-time. (14) With complete capital markets, one can hold financial positions that would pay off in every possible state of the world, thus providing effective insurance against any possible contingency. (15) Complete markets are necessary to the full achievement of allocative efficiency in the economy. (16) In the income averaging and income versus consumption tax debates, their absence would mean that people with the same lifetime resources might actually face very different circumstances in each period, suggesting that they should not necessarily pay the same lifetime taxes.

2) Consistent rational choice. Under conventional economic assumptions, people have stable preferences that determine the utility they will experience in alternative states of the world and that they consult to make decisions aimed at maximizing expected utility. (17) People therefore are assumed to engage in consistent rational choice, suggesting that they will make the same choice from within a given opportunity set no matter how the choices are presented or framed. Weakening this assumption, by positing that people are myopic, for example, can undermine the cases for income averaging and consumption taxation by suggesting that behavior and well-being may significantly depend on current period resources, rather than simply on the lifetime total.

3) Within-period information. A final assumption underlying use of the long-term perspective to support income averaging and consumption taxation relates to achieving the tax system's distributional objectives, rather than to the choice of analytic timeframe as such. Specifically, this assumption holds that, once one has picked the relevant period for evaluating how well-off people are (such as by measuring their income or consumption for the period), information about when within the period the taxpayer acted or benefited does not provide further useful guidance for distribution policy. Thus, in an annual system, people who earn or spend a lot in January typically are treated the same as those who ended the year in the same overall position but followed a different sequence (such as earning or spending more evenly across time, or with back-loading instead of front-loading). With a lifetime perspective, this assumption becomes more controversial. The gap between, say, the ages of 21 and 75 is much bigger than that between January and December of a single year. An individual may change much more during such an extended period, and the tax system may have much more to gain informationally from looking within the period, rather than just at total results for the period as a whole. This undermines the case for income averaging and consumption taxation by suggesting that the particular sequence of the taxpayer's earnings and/or consumption, not just the taxpayer's lifetime income, should affect how she is treated both overall and at different times within her lifespan.

In this Article, I will show that none of the three assumptions that are needed to make an overwhelming case for income averaging and consumption taxation fully holds. Incomplete markets and departures from consistent rational choice can make current-period information about an individual's circumstances relatively more important than consumption taxation and income averaging effectively recognize. The effect, however, is more to muddy the analysis than affirmatively to support income taxation or a predominantly annual system.

Problems with the third assumption, pertaining to within-period information, potentially have stronger implications. As we will see, the relevance of the within-period components of lifetime information can affirmatively support taxing saving, in keeping with an income tax but not a consumption tax. In addition, in some circumstances there may be grounds for imposing higher taxes on people with declining earnings than on those with level earnings, in keeping with an annual but not a lifetime-based system if both have graduated marginal rates.

Collectively, these departures from the three assumptions refute the core conclusion of a recent leading article that "based on current understanding, ideal consumption taxes are superior to ideal income taxes." (18) Reality is simply too messy for overly definite real world conclusions about the relative merits of these two systems to hold outside the contours of stylized and simplified models. Indeed, while adopting a particular tax base ideal may make sense politically--and, in this sense, I will argue that the case for shifting to a consumption tax ideal remains strong--from a pure intellectual standpoint the abstract quest for the better "ideal tax base" is misguided. To tax either income or consumption is to operate at too great a distance from the imperfectly observable attributes of individuals that we might actually want to use in allocating tax burdens for either ideal to dominate unambiguously.

For income averaging, the current consensus lies in such a different place that the identical counsel of skepticism has different implications. Despite the lack of a convincing case for lifetime income averaging as a general ideal, in various circumstances it seems likely to allocate tax burdens more equitably and efficiently than a purely annual system. Thus, there should be further exploration of how a limited income averaging system might work.

The discussion in the remainder of this Article proceeds as follows. Part I offers important background by describing the "optimal income tax" literature that has emerged in public economics over the last thirty-five years and that offers a systematic framework for thinking about tax and distribution policy. Part II discusses the case for income averaging, which depends on the merits of an important application of the complete markets and consistent rational choice assumptions. This is the permanent income hypothesis of Milton Friedman, (19) under which people's consumption decisions are based on their expected lifetime incomes, not on how much they earn in a given period. Part II also explores the significance for income averaging of modifying the assumption that distribution policy must rely exclusively on static information about overall lifetime earnings. In doing so, it makes use of an emergent branch of the economics literature, known as new dynamic public finance (NDPF), that is as yet little known to legal scholars. Part III discusses the case underlying the new pro-consumption tax consensus and shows how extensively it relies on the same assumptions as those that support income averaging and thus is subject to similar objections. Part IV offers a brief conclusion.

I. THE OPTIMAL INCOME TAX FRAMEWORK

A. Optimal Income Taxation and the Underlying Information Problem

To evaluate the cases for income averaging and consumption taxation, it is important to start at a foundational level. Why would we have an income or consumption tax, let alone a tax with graduated marginal rates that makes the total tax liability of individuals with fluctuating incomes depend on the choice of period? Within welfare economics, which studies the "determinants of well-being, or welfare, in a society," (20) this inquiry has led over the last thirty-five years to the development of what is called the optimal income tax (21) (OIT) literature. (22)

This Part briefly describes the features of this literature that are most pertinent here. To help prepare the way, however, it is worth noting up front (without attempting yet to justify) several key features of the OIT literature that may initially prove surprising or counterintuitive. Tax policy literature that predates the spread of welfare economics typically assumes that one's preferred tax base--be it income, consumption, or something else--is actually the very thing one really wants to tax. (23) OIT looks deeper, and treats these measures as merely evidence of something else that we cannot directly observe.

Going one turtle down, (24) the attribute of interest is earning ability, whether or not exercised. If we are concerned, as this literature is, with identifying better-off and worse-off individuals, on the view that there are strong normative grounds for redistribution from the former to the latter, the fact that someone with high earning ability prefers not to exercise it in full carries no implication that this exercise of preference made her worse-off than if she had done so. We have no reason to think, for example, that rational non-workaholics are generally worse-off than their more compulsive brethren. Another way of putting this point would be to say that, all else equal, people with greater opportunities seem likely to be better-off than those with lesser opportunities.

Even ability, however, remains at least a turtle shy of the bottom layer. In welfare economics, the sole criterion for assessing a given policy is its effect on social welfare, which "depends on how [the policy] influences individuals' well-being and on nothing else." (25) Thus, ability matters not for its own sake, but as evidence, in turn, of something else--people's total utility and marginal utility, the latter of which describes how much one's total utility would change if additional resources were given to or taken away from one.

This brings us to the core problem. Total and marginal utility cannot be directly observed. Even ability cannot be directly observed, since actual earnings depend on one's level of effort--itself unobservable, even if we could count people's hours of work, since time is only one of the margins at which people can vary it. (26) Accordingly, deciding how much tax different individuals should pay (or what transfers they should receive), (27) like so much else in modern law and economics, turns into a problem of incomplete and asymmetric information. Social policy decisions ought to be based on attributes that cannot be directly observed, and as to which individuals, relative to policymakers, have private information about themselves.

Accordingly, in choosing a tax base, such as income or consumption, along with a period for applying graduated marginal rates, such as a year or a lifetime, we are blundering around several layers short of where we would really like to be. The optimal choice of tax base and tax period depend, among other factors, on how well the different alternatives would make use of any information bearing on total and marginal utility that actually is available. Moreover, once we start thinking about all of the available information, we are not necessarily limited to making simple binary choices between income and consumption taxation, or between annual and lifetime-based systems.

B. Taxation and Inequality

From the standpoint of efficiency, any income or consumption tax, whether with flat or varying rates, is dominated by a lump-sum tax, or one in which each taxpayer's liability is fixed without regard to any decisions that she makes. (28) Income and consumption taxes discourage work and market consumption, and an income tax additionally discourages saving. (29) A lump-sum tax could take an infinite number of different forms, including (1) a uniform head tax, (30) (2) a reverse lottery to assign tax liabilities randomly, and (3) a tax based purely on people's eye color. Despite its virtues from the standpoint of efficiency, such a tax is almost never seriously proposed. (31)

The reason for not having any feasible lump-sum tax is simple. Some people are better-off than others, and it is widely believed that those who are better-off should pay more tax. Thus, many would agree that Bill Gates should pay more than the average reader of this Article, who in turn should pay more than a homeless person. This sometimes is called the criterion of ability to pay, perhaps reflecting assumptions about the effect of material well-being on the disutility of paying.

In modern welfare economics, the notion of being better-off is commonly interpreted in terms of a budget line, reflecting the maximum combinations of available resources that an individual can acquire. Having a higher budget line suggests being better-off, all else equal, if we make two assumptions. The first is the psychological assumption of non-satiation, i.e., that more of any good is always better than less. (32) Thus, if there are only two consumer goods, A and B, that are perfectly tradable for each other in complete markets, raising one's budget line means that one can get more of either or both without having to give up anything. Under non-satiation, this implies being better-off, again holding all else equal. The second assumption repeats the old maxim that there is no accounting for taste, or more precisely, that merely observing differences in taste does not immediately tell us anything about, say, who is happier or making better choices or cares more about satisfying her preferences. Drawing any such conclusions from observed differences in taste is not ruled out, but it would require supporting evidence.

Against this background, suppose that we assume two goods: (1) market consumption, comprising everything one could buy for cash, and (2) leisure, comprising not just free time but any use of one's time other than to earn as much money as possible. Everyone has twenty-four hours in a day,...

NOTE: All illustrations and photos have been removed from this article.



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