Ambiguity and Income Taxation

Abstract

Traditional analysis of tax policy has generally used either the Expected Utility Model or the closely related Subjective Expected Utility Theory to describe how individuals behave under risk and uncertainty. However, the accuracy of this theory has been under attack for a number of decades. This article begins the process of incorporating one of the major lines of criticism of expected utility theories, i.e. that individuals don't necessary calculate precise probabilities of events and are averse to ambiguous risks, into the analysis of tax policy. It discusses how this analysis explains certain 'paradoxes' such as the 'Home Bias' problem. It concludes that these findings argue for lower rates of taxation on entrepreneurial income and for lower rates of tax on portfolio income derived from investment in foreign countries.