COLLOQUIUM ON TAX POLICY AND PUBLIC FINANCE SPRING 2013 “ Taxation , Risk , and Portfolio

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. I. Introduction.................................................................................................. 2 II. The Domar-Musgrave Result.................................................................. 7 A. The Model...........................................................................................................9 B. Taxpayer Perspective..................................................................................... 10 C. Government Perspective ............................................................................... 12 D. Assumptions and Conditions ...................................................................... 14 1. Proportionate Tax ......................................................................................................15 † Associate Professor of Law, Georgetown University Law Center. I am grateful to Jennifer Bird-Pollan, Stephen Cohen, Lillian Faulhaber, Mihir Desai, Michael Doran, Michael Graetz, Itai Grinberg, Daniel Halperin, Louis Kaplow, Wojciech Kopczuk, Alex Raskolnikov, David Schizer, Stephen Shay, Theodore Sims, Joshua Teitelbaum, David Walker, Alvin Warren, Ethan Yale, Kathryn Zeiler, and participants in workshops at Columbia Law School, Georgetown University Law Center, and Harvard Law School for helpful conversations, comments, and suggestions. I am also especially grateful for the valuable research assistance of Yingchen Luo and Eric Remijan. TAXATION, RISK, AND PORTFOLIO CHOICE 2 2. Single Tax Rate ............................................................................................................16 3. Government Portfolio Policy ..................................................................................16 E. The Problem.................................................................................................... 18 III. Investment Risk and Portfolio Theory ..............................................19 A. The Problems with Variance ........................................................................ 19 B. The Limits of the Mean-Variance Model .................................................. 21 C. Stochastic Dominance................................................................................... 23 D. Loss Aversion and Safety First .................................................................... 26 E. Value at Risk ................................................................................................... 29 F. Summary........................................................................................................... 32 IV. The Domar-Musgrave Result Under a Safety-First Risk Measure 33 A. An Income Tax Taxes Risky Returns ........................................................ 33 1. Investor Perspective...................................................................................................33 2. Government Perspective ..........................................................................................35 B. A Tax on the Risk-Free Return Taxes Risky Returns ............................ 35 1. Investor Perspective...................................................................................................36 2. Government Perspective ..........................................................................................37 C. What Is Being Taxed? ................................................................................... 38 D. The Risk-Free Rate ....................................................................................... 40 E. Derivatives ....................................................................................................... 43 V. Implications for the Debate Between an Income Tax and a Consumption Tax.............................................................................................45 A. Differential Treatment of Labor and Capital ............................................ 45 B. Differential Treatment of Winners and Losers......................................... 48 VI. Conclusion ...............................................................................................49