Capital Income Taxation and Risk-Taking under Prospect Theory: The Continuous Distribution Case*

Abstract

This study verifies whether the results of proportional capital income taxation on the risk-taking of a loss-averse investor will still hold when the return of a risky asset has a general continuous distribution. We extend the previous literature, which assumes a binomial distribution of asset returns for a risky asset. We also show that under reasonable assumptions risk-taking is finite and positive and thus a loss-averse investor will not choose infinite leverage despite no regulations being applied. In addition, unlike in the expected utility model, the capital income tax increase does not stimulate risk-taking when the reference level is the initial wealth or the gross after the tax return from investing the initial wealth into the risk-free asset. Furthermore, when investors set their reference level at the gross (pre-tax) return from investing the initial wealth into the risk-free asset, they increase not only risk-taking but also their private risks as measured by the standard deviation of their after-tax final wealth, which is not the case in the expected utility model.

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