Tax Policy under Uncertainty

Faced with uncertain future costs, should governments take immediate action or wait to see precisely what is needed? Intuitively, decision makers are more likely to take immediate and larger action, the higher the perceived probability of the contingency arising, the larger the potential cost, and the higher their degree of risk aversion. This chapter clarifies the nature of the various relationships, and the orders of magnitude involved, in the context of simple multi-period models. A single judge is considered to select an optimal tax policy by maximising a social welfare, or evaluation, function expressed in terms of net incomes in each period. The chapter explores the nature of the trade-offs involved. Important components of the model concern the excess burden of taxation, and specifications of the judge's evaluation function and its implied risk aversion characteristics.