The Taxation of Risky Investments: An Asset Pricing Approach

Abstract

Some economists have argued that offsetting effects on risk and return may make capital income taxes nondistorting. This paper performs three tasks. First, the conditions under which the argument is true are studied in an asset pricing model that unlike earlier models allows the timing of depreciation deductions to vary and incorporates the effectiveness and distribution of government expenditures. One result is that it is plausible that the nondistortion result holds regardless of that timing or of the distribution and effectiveness of expenditures if the pre-tax riskless rate is zero. A second task concerns the cases where the pre-tax riskless rate is not negligible and the nondistortion result does not hold. Then the degree and pattern of distortion depends on the general equilibrium impact of taxes and expenditures on average risk aversion and on the pre-tax riskless rate. An interesting result emerges concerning the impact of the timing of depreciation allowances. When average risk aversion stays constant, the conventionally expected effect that faster write-offs result in more investment will occur if and only if the pre-tax riskless rate falls when timing is accelerated. This is true because in the absence of any change in the pre-tax riskless rate, changes in depreciation timing cause changes in risk and expected return that exactly off set each other. Finally, the paper shows that the failure to add a premium for "capital risk" to the standard economic depreciation allowance based on expected decline in asset value does not change that result unless the income tax system has the pathology of allowing used asset sales to be tax free. The current U.S. tax system seems to be free of that pathology.

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