The Effect of Income Taxation on Risky Investment: An Experimental Test of the Domar-Musgrave Hypothesis

Abstract

In this experiment, we test whether the Domar-Musgrave model accurately predicts investor behavior in its paradigmatic setting. Our results indicate that investors only scale up their investments in risky assets to the extent predicted by the model when tax rates are relatively low. Moreover, we found a portion of the subjects decreased investments in risky assets as a reaction to the imposition of symmetric capital taxes. For these subjects, we found that the return on the risky asset in the immediate prior period was a more important determinant of risk-taking.

Keywords: Income Tax, Capital Tax, Full Loss Offsets, Laboratory Experiment

JEL Classification: H21, H24, C91