Taxation, Political Risk and Portfolio Selection

Abstract

In various analyses of the effect of income taxation on an investor's willingness to invest in assets whose rates of return are uncertain, it is an underlying assumption that the investor knows for certain the rates at which his income will be taxed.' The only uncertainty then attaches to the before-tax rates of return on the risky investments. This paper concentrates on cases where at the time of selecting a portfolio an investor has incomplete knowledge of the tax rates which will be effective in the future. This may be the situation in a parliamentary election year if rival parties are in favour of corporation income taxation and consumption taxation, respectively. In some countries uncertainty about tax rates may be a more permanent feature; for example, at all times there may be a non-zero probability of complete confiscation of investment profits. Under such circumstances the tax rate can appear as a random variable from an investor's point of view. In this way uncertainty about after-tax income can reflect uncertainty as to the tax rates which eventually will become effective-political risk-as well as uncertainty as to before-tax returns-commercial risk. The separation of political risk from commercial risk enables us to study the specific effects of uncertainty about the relevant tax rates when a portfolio decision is made.2 The measurement of political risk is a difficult problem since many measures of risk are associated with certain classes of utility functions and/or probability distributions.3 A non-zero variance of the tax rate is a sufficient and necessary condition for the existence of political risk. Representing changes in political risk in terms of changes in the variance of the tax rate is to be avoided, however, as such a representation would be legitimate only under rather restrictive assumptions. We define a change in political risk in terms of a corresponding change in a dispersion shift parameter which indicates the stretching or compression of the probability distribution of the tax rate around its expected value.4 When the value of the dispersion parameter changes,