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 tar system to a proportional one because the tar burden is lower when they are young and face high transactions costs of borrowing. Similarly, an income tar is preferred to a consumption tar. 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 far system. Exemption of financial services will generally be desirable.