Risk Taking and Optimal Taxation in the Presence of Nontradable Human Capital

Abstract

This paper demonstrates that the stream of uncertain income from human capital has systematic effects on the demand for risky physical capital assets. If labor supply is inelastic and real wages are known with certainty, then a labor income tax will reduce holdings of the risky physical asset. However, if labor income fluctuates randomly, a labor income tax may actually raise demand for the asset if human capital risk and physical capital risk are positively correlated. The idiosyncratic risk and nontradability of human capital also have implications for optimal taxation.