Our analysis reveals that tax rate uncertainty imposes substantial welfare costs equivalent to 0.4-1.2% of GDP annually. These findings fundamentally reshape our understanding of optimal tax design and highlight the importance of policy transparency.
The concentration of welfare losses among middle-income households contradicts conventional wisdom. These households navigate the most complex parts of the tax code, where multiple provisions interact to create uncertainty about effective marginal rates. Unlike high-income taxpayers who can afford professional assistance or low-income taxpayers who face simpler rules, middle-income families bear a disproportionate burden from tax uncertainty.
These results help explain why observed tax rates fall systematically below theoretical optima. When policymakers account for uncertainty costs, either explicitly or intuitively, they rationally choose lower rates than perfect-information models suggest. This insight bridges the gap between academic recommendations and political reality.
The non-insurability of tax rate uncertainty distinguishes it from other economic risks. While financial markets can price and hedge many uncertainties, no market exists for tax rate insurance due to moral hazard—the government controls the underlying risk. This market failure justifies policy intervention to reduce uncertainty at its source.
International comparisons strengthen our conclusions. Countries with simpler, more stable tax systems show lower welfare losses, while those with complex, frequently changing codes show higher losses. Institutional features like fiscal rules and legislative norms against retroactive taxation can meaningfully reduce uncertainty costs.