Perception and Income: The Behavioral Economics of the Realization Doctrine

Abstract

The requirement that gains be "realized" before they are subject to income tax is one of the most fundamental doctrines in tax law as well as being one of the most controversial. The common assumption in the academic literature is that this requirement leads to significant inefficiencies and inequities. This article argues that requiring a realization event is generally the best way to measure taxable income because it is consistent with how individuals actually perceive income. This perspective helps us to understand the development of the realization doctrine as well as suggest ways in which the current tax system can be improved, such as exempting some of the amounts reinvested in mutual funds from income taxation.

Keywords: Tax, tax law & policy

JEL Classification: K34