>> 1) If offspring results, it'll probably have some severe genetic problems. Big deal, don't have kids.
> 1) Incorrect. Incestuous children do not have a significant increase in rates of retardation or anything else.

Inbreeding always increases the odds of recessive genetic diseases exhibiting themselves. Now, in a single case of inbreeding the odds may not be as high, but it is well known that heavily inbred groups of organisms suffer many more genetic defects - refer to old royal families, for instance.

Now, this part is purely speculation on my part, but it seems to me that this would create an evolutionary pressure away from incest, giving animals an instinct to avoid incest. The societal taboos and moral rules against it could very well just be the result of those instincts.

Leading me to the conclusion: Dumb animals shouldn't practice incest, but intelligent human who know what they're getting into and make sure they don't have children could very well do it, if they can ignore the evolutionary pressure not to. And we're good at doing that.

The psychological side may or may not be significant though, I couldn't tell.