Taxation, Risk, and Portfolio Choice: The Treatment of Returns to Risk Under a Normative Income Tax

51 Pages Posted: 3 Aug 2013

See all articles by John R. Brooks

John R. Brooks

Georgetown University Law Center

Date Written: 2013

Abstract

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

Brooks, John R., Taxation, Risk, and Portfolio Choice: The Treatment of Returns to Risk Under a Normative Income Tax (2013). Tax Law Review, Vol. 66, pp. 255-304, 2013, Available at SSRN: https://ssrn.com/abstract=2304193

John R. Brooks (Contact Author)

Georgetown University Law Center ( email )

600 New Jersey Avenue, NW
Washington, DC 20001
United States

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