Taxation and Risk-Taking with Multiple Tax Rates

This paper extends the literature on the effect of an income tax on risk taking to the case where different tax rates apply to different types of assets. It shows that an income tax that nominally imposes different rates on the full return to investments can be recharacterized as a uniform tax on the risk–free rate of return to all investments plus a fixed subsidy or penalty. The subsidy or penalty depends only on the risk–free rate of return and the relative tax rates. Therefore, differential taxation does not affect risk. Moreover, for a reasonable range of parameters, the subsidy or penalty is small. The implication is that measurements of the deadweight loss from differential taxation may be too high by an order of magnitude. In addition, expenditures on reducing differential taxation, such as to make the income tax more accurate, may not be worthwhile.