Capital Income Taxation and Risk Spreading with Adverse Selection

Kai Konrad and Wolfram Richter

Canadian Journal of Economics, 1995, vol. 28, issue 3, 617-30

Abstract: E. D. Domar and R. A. Musgrave (1944) showed that taxing the return from risky investments may encourage risk taking. The effect has come under attack as being one of partial analysis that would disappear in general equilibrium. This paper shows that the contrary is true if capital markets suffer from adverse selection. Asymmetric information induces investors to bear risk that could be spread in the capital market. The tendency to such behavior may be increased by a tax on risky capital income. In that case, social risk spreading decreases, while the opposite effect would hold if general equilibrium repercussions were ignored.

Date: 1995
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