DP4053 Taxing Risky Investment

Author(s): Michael P. Devereux

Publication Date: September 2003

Keyword(s): capital income tax , investment

JEL(s): E22 , H25 , H32

Programme Areas: Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP4053.asp

This Paper re-examines the impact of capital income taxes on the incentive to invest in the presence of risk. Specifically, it challenges a well-known claim in the literature that such a tax can leave incentives ‘basically unaffected’ because the tax liability is offset by a reduction in the post-tax risk of the investment. The Paper argues that this claim is based on a misinterpretation of the cost of capital, and that in general the cost of capital is not helpful in assessing investment incentives in the presence of risk. Instead it proposes an alternative measure, based on the market value of the pre-tax stochastic cash flows. This measure indicates that the disincentive effect of capital income taxes can be substantial.