Permanent Income and the Annual Income Tax

Abstract

Under a prominent and influential economic model known as the permanent income hypothesis, people's decisions depend on their expected lifetime income, not their current income. If completely true, this hypothesis would have radical implications for tax, transfer, and entitlements policy. For example, unless modified by other information, it would suggest replacing the income tax with a consumption tax, establishing lifetime income averaging, viewing Social Security as irrelevant other than as a system for transferring lifetime resources between individuals, and dramatically changing welfare law to base aid purely on people's lifetime income, as distinct from their current circumstances. However, incomplete markets and departures from rational behavior, by shortening people's planning horizons, weaken some of permanent income's implications and refute others.