Risk-Taking and Optimal Taxation with Nontradable Human Capital

IMF Working Papers, December 1, 1992

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Risk-Taking and Optimal Taxation with Nontradable Human Capital

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Bibliographic details

• Authors: Zuliu Hu
• Published: December 1, 1992
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451947427.001

Summary and research question

• Investigates: What are the effects of taxation on individual/entrepreneurs’ risk-taking behavior?
• Approach: Re-examines the question in a continuous time life-cycle model.
• Central insight: The stream of uncertain income from human capital has systematic effects on demand for the risky physical capital asset.

Key findings on risk-taking and taxation

• If labor supply is inelastic and real wages are known with certainty, then:
  • A labor income tax will reduce holdings of the risky physical asset.
• If there are random fluctuations in labor income, then:
  • The effect of a labor income tax on demand for the risky physical asset depends on the nature of interaction between wage risk and investment income risk.
  • A labor income tax may raise demand for the risky capital asset if human capital risk and physical capital risk are positively correlated.
• The idiosyncratic risk and nontradability of human capital have systematic implications for demand for risky assets.

Implications for optimal taxation

• When the insurance and disincentive effects are jointly taken into account:
  • A Pareto efficient tax structure implies a strictly positive tax rate.

Model and mechanism details (as described)

• Framework: Continuous time life-cycle model.
• Key mechanisms emphasized:
  • Interaction between wage risk and investment income risk.
  • Nontradability of human capital.
  • Insurance effects versus disincentive effects in tax design.