THE EFFECTS OF ALTERNATIVE INCOME TAX STRUCTURES ON RISK TAKING IN CAPITAL MARKETS

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Abstract
This paper investigates the effects of proportional and progressive taxes on investor demand for capital assets. Investors who are otherwise indifferent to fair gambles are shown to require a risk premium to induce them to hold risky assets when returns are subject to progressive taxes. Risk-neutral investors would find it optimal to hold diversified portfolios, since this maximizes expected after-tax returns. When investors are risk-averse to begin with, the paper shows that for an important special case, the demand for risky assets decreases in the face of a progressive tax, whereas proportional taxes increase the desirability of holding risky investments.

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