In this thesis we explore political and market equilibria in worlds with income taxes. In part I we study individual and majority-rule choice of an income tax schedule in the context of a simple two-sector economy in which individuals respond to higher taxes by earning less taxable income and devoting more time to untaxed activities. If voters are concerned with the "fairness" of the distribution of after-tax incomes in society, then a majority-rule equilibrium tax schedule exists, and is linear. If voters care primarily about their own after-tax income however, then in general no such equilibrium exists, although equilibria may exist within special classes of taxes. In characterizing individual preferences, we find that "middle-class" voters prefer sharply progressive schedules that impose low marginal tax rates on lower-income taxpayers and high marginal rates on upper-income taxpayers. This suggests that the observed preference for marginal-rate progression has little to do with "fairness," but results from the middle-class' successfully reducing its own tax burden.
In Part II we study the effects of income taxation on capital asset market equilibrium, using a popular model of asset pricing, the Arbitrage Pricing Theory (APT). We focus on two features found in many tax codes, the differential treatment of dividends and capital gains, and the different treatment of various types of investors. We show first that, with restrictions on the portfolios investors may hold, in general at any prices there will be some investor who can make unlimited arbitrage profits. Next we restrict portfolios, requiring that no investor borrow so much that her total dividend payment on short sales exceeds her total dividend income on the assets she owns. Given this restriction there exist prices at which no investors can make unlimited arbitrage profits. We show that if at least one investor faces a higher tax rate on capital gains than dividends (true for corporations in the U.S. today) then the prices must be different from those predicted by the APT without taxes.
