Thomas Brennan (Northwestern) presents Certainty and Uncertainty in the Taxation of Risky Returns at NYU today as part of its Colloquium Series on Tax Policy and Public Finance.  The co-convenors are Daniel Shaviro (NYU) & Alan Auerbach (UC-Berkeley, Department of Economics).  Here is the abstract:

Existing research has shown that a proportionate tax on income is equivalent to a tax on the risk-free rate of return applied to capital. What is not so well understood is the nature of non-proportionate taxes on income, such as those having loss disallowances or progressivity features. I extend the general equilibrium techniques traditionally applied to proportionate taxes to gain better understanding of more realistic non-proportionate taxes. I frame the question of how to go about this extension by analogizing proportionate taxes to financial forwards and more general taxes to structured financial options, and I find that option pricing theory and methods carry over naturally. In general, I find that the burden of an income tax is akin to the price of a corresponding option and that non-proportionate income taxes generally burden risky returns just as option prices generally reflect the volatility inherent in risky assets. I develop the theory in most detail in the case of binomial asset returns, and I particularly focus on the example of a tax that is proportionate for gains but allows no deduction for losses. The binomial context and this example are illustrative of the general ideas and serve to show the degree to which risky returns are burdened by even a simple deviation from strict proportionality. I also go on to lay out the ideas and structure for extending the analysis to very general tax systems and to continuous, rather than binomial, risky returns. The results obtained show broadly that non-proportionate income taxes burden risky returns on assets in precise, systematic and quantifiable ways. This new theoretical result calls for a revision of the traditional understanding of what an income tax is able to, and does, accomplish in terms of burdening risky components of return.