Taxation when Borrowing is Costly

The implications for taxation theory of a life‐cycle model of consumption incorporating financial transactions costs are derived The equity case for progressive taxation is shown to correspond in a life‐cycle setting, to an efficiency case. Individuals prefer a progressive tax system to a proportional one because the tax burden is lower when they are young and face high transactions costs of borrowing. Similarly, an income tax is preferred to a consumption tax. Unlike earlier models based on liquidity constraints, the model presented here involves a financial sector consuming real resources. This permits analysis of the tax treatment of financial services in a consumption tax system. Exemption of financial services will generally be desirable.