Taxation, Risk, and Portfolio Choice: The Treatment of Returns to Risk Under a Normative Income Tax
51 Pages Posted: 3 Aug 2013
Date Written: 2013
Many articles in the legal and economic literature claim that a pure Haig-Simons income tax cannot effectively tax investment income. This is because an investor can use leverage to gross up her investments in risky assets such that the increased gain (or loss) exactly offsets any income tax (or deduction) on the returns to risk-taking. This article argues, however, that while it is possible for an investor to make such portfolio shifts, she almost certainly will not because of the increased risk of doing so.
Central to any discussion of the effects of taxation on investment risk-taking is the meaning of risk itself. The central claim of this article is that a better conception of investment risk is the risk of loss and not merely the variance of returns. Applying this notion of risk — one that is well supported in the finance literature but new to the taxation-and-risk literature — to an investor’s portfolio choice question shows that an investor will not increase her investment in risky assets by enough to offset the tax. As a result, there is an effective tax on investment risk-taking under a normative income tax.
Keywords: income taxation, taxation and risk, portfolio theory
JEL Classification: K30, K34, K39
Suggested Citation: Suggested Citation