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Summary of WP/92/105

Author(s):
International Monetary Fund
Published Date:
January 1993
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Summary of WP/92/105

“Risk-Taking and Optimal Taxation with Nontradable Human Capital” by Zuliu Hu

Although governments and the public generally take a favorable view of individual/entrepreneurial risk-taking activity, the question of how public policy, such as taxation, affects this risk-taking behavior continues to be debated.

This paper re-examines the question in a continuous-time life-cycle model. First, individuals’ optimal consumption and portfolio rules in the case of two assets--one risk free, the other risky--are derived. Risk-taking can then be conveniently measured as demand for the risky asset or, alternatively, investment in the real production process. According to common assumptions about investor preference, individuals will hold a constant share of the risky physical asset all the time. When human capital is introduced, however, the optimal portfolio share of the risky asset will be age-dependent insofar as human capital varies over the life cycle. When labor supply is inelastic and real wages are known with certainty, a labor income tax reduces risk-taking.

This conclusion will no longer hold true if there are random fluctuations in labor income. The paper demonstrates that the uncertain income from human capital has systematic effects on risk-taking behavior. The exact effects of a labor income tax will generally depend on the covariance of human capital risk and physical capital risk. Surprisingly, when the two are positively correlated, a labor income tax may actually encourage risk-taking, owing to investors’ hedging demand.

Finally, the paper examines how the risk and nontradability of human capital can affect the optimal tax structure. If human capital risk is idiosyncratic--that is, if there is no aggregate shock--government taxation of labor income essentially provides insurance for individuals insofar as moral hazard causes a breakdown of private markets. When the insurance role of labor income taxation and its disincentive effects on labor supply (assuming labor supply is elastic, of course) are jointly taken into account, a Pareto-efficient tax implies a strictly positive tax rate.

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