Transferring Risk Preferences from Taxes to Investments

Abstract

Prior studies demonstrate that tax considerations can influence a taxpayer’s investment decisions. By itself, this is not very surprising because the investment decisions in these studies resulted in either increasing or decreasing the tax refund or tax payment. The aim of the present study is to re-examine this relationship in order to isolate the possible psychological effects of year-end tax position. We do this by controlling the economic tax consequences of the investment decisions and by relying on theories of mental accounting for our predictions. Results of two experiments demonstrate that taxpayers are psychologically more likely to hold stocks when they owe a tax payment than when they receive a tax refund, despite the absence of economic tax consequences. Furthermore, this behavior generalizes to stocks with gains and to stocks with losses. The results are consistent with a mental accounting application of prospect theory in which risk preferences in one area (taxes) can potentially influence risk preferences in other areas (investments).

Keywords: Investments, Mental Accounting, Prospect Theory, Risk Preferences, Taxes

JEL Classification: H2, M4