The Treatment of Risk-Taking Under an Income Tax

Abstract

A true income tax is conventionally considered unable to burden the returns to risk-taking. The theory is that investors respond to the tax by increasing the amounts they invest in assets delivering risk-based returns. If the increased investment makes money, the enlarged return covers the associated tax liability; if it loses money, the enlarged deduction cushions the loss.

This paper argues that the conventional view is mistaken. Investors generally will be unable to increase their investments to compensate for the tax, implying that the government collects revenue to the extent returns to risk-bearing are positive. Apparently contrary results derived in the general equilibrium literature are due to the unrelated (and generally unwarranted) assumption that the government operates under a budget constraint incompatible with its retention of revenues from the tax on risky returns. The argument is significant in light of the important ramifications of the conventional view.

Keywords: taxation, public finance

JEL Classification: H02, H20, K34