The Effects of Taxation on Risk Taking

Abstract

The proposition that a proportional tax with full loss offset increases personal taking is now widely accepted by professional economists. This conclusion, originally suggested by Domar and Musgrave (1944), has more recently been reached by several economists working in context of von Neumann-Morgenstern expected-utility maximization (Tobin 1958; Hall 1960; Richter 1960; Penner 1964). A heuristic argument to reconcile this rather surprising result with intuition would be something like this. Because imposition of a tax decreases both yield and risk of all assets, it increases investor's demand for higher yield (raises the utility of income) and reduces his resistance to assuming more (lowers marginal disutility of risk). If tax lowers yield and of every security in same proportion (as occurs with yield and measures considered by previous writers), market risk-yield rate of transformation is unchanged. The result is an increased demand by investors for higher yielding and more risky assets. The purpose of this paper is to demonstrate that assertion that proportional taxation causes individuals who maximize expected utility' to increase taking is not generally true. Section I shows that previous attempts to prove that taxation increases taking have relied on a variety of restrictive and implausible assumptions. Section II then argues that concept of taking (and therefore of tax base) should be extended beyond portfolio choice and, in this framework, offers a counter-example to general proposition that taxation increases taking.