Taxation and Risk-Taking with Multiple Tax Rates
Social Science Research Network
This paper extends the Domar and Musgrave results concerning the effect of an income tax on risk taking to the case where different tax rates are applied to different types of assets. Although the results depend on exactly how the differential tax rates are imposed, as a general matter, an income tax with differential rates can be seen as a tax only on the risk-free rate of return and an ex ante subsidy for purchasing the lower-taxed assets. There are implications for measuring deadweight loss
... ng deadweight loss from differential taxation and for spending resources on accurately measuring capital income. Send comments to: email@example.com * Professor, The University of Chicago Law School. I thank Joe Bankman for comments. Since Domar and Musgrave (1944) and subsequent literature, it has been generally known that taxpayers can make portfolio adjustments that effectively eliminate the portion of an income tax nominally imposed on the risky return to investments. 1 It follows that a pure capital income tax is equivalent (both ex ante and ex post) to a tax on the riskless return on all assets. The most widely discussed implication of this conclusion is that it means there is little difference between an income tax and a consumption tax, and no difference at all between and income tax and a wealth tax. 2 In addition, the conclusion has been used to design taxes that are equivalent to an income tax but easier to administer. 3 The proofs of this proposition are now fairly general. They place minimal restrictions on the utility function of individuals and they apply in a general equilibrium context. Most proofs are stated in terms of a choice of just two assets, a risky and a risk-free asset, but recent models are easily extended to multiple assets. Some models place few, if any, restrictions on the use of government revenues. An important detail left out of the current models, however, is the possibility of different tax rates on different types of capital. 4 Differential tax rates arise both because of purposeful deviations in tax rates, such as the corporate tax or special subsidies, and because of the difficulty in measuring capital income. They are an endemic feature of income taxes. This paper shows how the Domar/Musgrave results extend to this case. In particular, when there are differential tax rates on capital, taxpayers, as a general matter, can eliminate the tax on the risky return to capital in exchange for a fixed subsidy for purchasing the lower-taxed asset. The subsidy is based on the difference in the tax-exclusive tax rates on the risk-free rate of return for different types of capital. The exact nature of the portfolio adjustments, the costs of the adjustment, and even the ability to make such an adjustment, however, relate to the details of how differential tax rates are imposed. There are a number of important policy implications of this conclusion. First, the conclusion affects the size of the deadweight loss is from differential capital income taxation.