Rebecca N. Morrow
Volume 76, Issue 5, 1373-1428
I confess. As a tax professor, it has long hurt my feelings that economists label tax as a market distortion. My field is summed up as an impurity on the otherwise pristine complexion of the economist’s pure market. I like to think that tax scholars are not so disparaging of economics. We do not view economically motivated action as a distortion to our tax system, but as a component of it. It is tax planning. This Article proposes that tax should be viewed as a component of a market system. Just as tax scholarship acknowledges that an imagined world in which tax is imposed in isolation does not and cannot exist, might economic scholarship similarly concede that it lacks a robust basis to characterize tax as a distortion to the market, as opposed to a component of it? After all, could a market exist without government enforcement of market rules, and could a lasting, functioning government exist without tax?
This Article argues that an income tax is the vestibular system of our market economy. It can balance the market and help send better information to our brains. Without an income tax to balance the otherwise harmful effects of excessive risk aversion, narrow framing, and the disposition effect, transactions would be made by brains that are preoccupied with avoiding loss. The market system would lean inefficiently against risk. Luckily, an income tax ramps up risk-taking and counterbalances risk aversion. Viewing tax as a component of a market system, rather than viewing it in isolation, reveals that the income tax corrects the market. It mitigates the harmful economic consequences of loss aversion.
The implications of this insight are significant. They support arguments that: higher income tax rates might fuel economic growth, loss offsets encourage risk-taking better than preferred rates do, and the realization requirement offers additional corrective power.