Capital Income, Risky Investments, and Income and Cash-Flow Taxation

Abstract

It has become conventional wisdom, based partly on postulated portfolio adjustments by investors in risky assets, (1) to view an income tax as equivalent to a tax levied only on the risk free return to capital and as therefore equivalent to a wealth tax; and (2) to view the difference between an income tax and a cash-flow consumption tax as limited to tax on the risk free return. I show that the propositions (1) equating an income tax to a tax on the risk free return, and (2) distinguishing an income tax from a cash-flow tax only by tax on the risk free return, are distinct. Drawing on the literature on optimal responses to taxation by holders of risky assets I show also that the postulated adjustments on which the second of those propositions depends entail implausible assumptions about behavior under uncertainty, and that the foundation for that claim is to that extent unsound. This in turn suggests that claims that the differences between income and cash flow taxation are minor should be treated with caution.