Progressive Income Tax and Risky Personal Income: A Real Options Perspective

Abstract

Progressive income taxation regimes can be modelled as a weighted portfolio of European Call options over an individual's gross taxable income. These options are struck at the tax bracket lower bound and weighted by the increment in the marginal tax rate. The government holds a long position in this 'taxation option', with the individual taxpayer holding a short position. Consistent with general option pricing, the present value of the government's claim on a taxpayer's income is larger for those whose taxable income is riskier. Unlike most holders of Call option contracts, the government has the ability to alter one of the fundamental inputs into the option price, that of the risk-free rate of return. I note the sensitivities of these claims to changes in the risk-free rate of return. When aiming to maintain the option's value, the government's risk-free rate sensitivity coincides with that of the taxpayer in the case of a volatility shock. In the case of an income shock, the government's interests generally conflict with taxpayers, especially those with lower taxable incomes.