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International Tax and Public Finance

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01.08.2012

Capital income taxation and risk taking under prospect theory

verfasst von: Jaroslava Hlouskova, Panagiotis Tsigaris

Erschienen in: International Tax and Public Finance | Ausgabe 4/2012

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Abstract

This research examines capital income taxation for a prospect theory investor under some acceptable in the literature reference levels relative to which are the changes in the level of wealth valued. Depending on the reference level, some results indicate that it is possible for a capital income tax increase not to stimulate risk taking even if the tax code provides attractive full loss offset provisions. However, risk taking can be stimulated when investors compare their reference level with others. Risk taking can increase also if the investor interprets part of the tax as a loss instead as a reduced gain. Then the investor becomes risk seeking and moves away from the discomfort zone of relative losses. This later response to taxation causes private risk taking to increase.

Vorheriger Artikel Should remittances be taxed or subsidized?

Nächster Artikel Games within borders: are geographically differentiated taxes optimal?

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See Domar and Musgrave (1944), Mossin (1968), Stiglitz (1969), Sandmo (1985), Ahsan (1974, 1989). However, Ahsan and Tsigaris (2009) demonstrated that discouragement of risky asset investment will occur even under full loss offset provisions if the government is no more efficient in handling risk than the private sector.

As an illustration, consider a one period model with one risky asset and money. Final wealth is W ₂=(1+α ₁ x ₂)W ₁, where W ₁ is initial wealth and α ₁ is the initial proportion of wealth allocated to the risky investment with a rate of return x ₂. If the investor chooses \(\alpha=\frac{\alpha_{1}}{(1-\tau)}\), when there is a proportional tax, τ, on the risky return, then the pretax final wealth is equal to the posttax value. Thus, the investor faces the same risky distribution after and pretax without loss of any utility.

See Proposition 2 in Stiglitz (1969). Decreasing absolute risk aversion is necessary for private risk taking to fall. See also Atkinson and Stiglitz (1980) for an exposition of the effects of capital income taxation and wealth on risk taking under the expected utility model.

A sufficiently loss averse investor is the one whose degree of loss aversion is high enough to guarantee not to undertake infinite leverage to invest or short sell the risky asset.

On p. 286, they state: “Although this is probably true for most choice problems, there are situations in which gains and losses are coded relative to an expectation or aspiration level that differs from the status quo. For example, an unexpected tax withdrawal from a monthly pay check is experienced as a loss, not as a reduced gain.”

Note that the empirical studies were done under a differential tax treatment of assets and with tax advantages on capital gains.

There are many other explanations as to why many households do not own stocks (i.e., liquidity constraints).

This is the typical Tversky and Kahneman (1992) specification. See Berkelaar et al. (2004), Gomes (2005), He and Zhou (2011), Hwang and Satchell (2010), and Bernard and Ghossoub (2010) for similar loss averse specifications.

Empirical evidence indicate that λ is statistically significantly greater than unity (Booij and van de Kuilen 2009).

Some research has used different curvature parameter, γ, in the domain of gains than in losses (γ ₁>γ ₂). See, for example, Hwang and Satchell (2010). However, empirical estimates indicate that one cannot reject the null hypothesis of nondifference in the value of γ in the domain of gains and losses (Booij and van de Kuilen 2009). In addition, such preferences (γ ₁>γ ₂) cause the risky asset to be an inferior good which is not empirically or theoretically supported.

Booij and van de Kuilen (2009) find the γ parameter to be (statistically) significantly less than unity.

The boundaries are easily obtained from requiring that W _2i−Γ ₂≥0.

It is possible for the investor to become aggressive toward investing in the risky asset if λ<1/K _γ or alternatively to aggressively short sell the risky asset when λ<K _γ. By aggressive we mean demanding infinite leverage (see He and Zhou 2011 or Hlouskova and Tsigaris 2012). As stated by He and Zhou (2011), this is an ill-posed problem as the investor will demand to buy or short sell an infinite amount of the risky asset. In this paper, we do not examine the ill-posed problems as they would require arbitrary limits to borrowing or risk aversion in the domain of losses.

The optimal solution could also occur in the short selling side provided the investor is sufficiently loss averse and \({\mathbb{E}}(x_{2}-r)<0\).

See footnote 13 for the conditions required to undertake risky investment. Future research should explore this area of investment for a not sufficiently loss averse investor and the effects of taxation.

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Titel: Capital income taxation and risk taking under prospect theory
verfasst von: Jaroslava Hlouskova
Panagiotis Tsigaris
Publikationsdatum: 01.08.2012
Verlag: Springer US
Erschienen in: International Tax and Public Finance / Ausgabe 4/2012
Print ISSN: 0927-5940
Elektronische ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-012-9224-1

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