CAPITAL INCOME TAXATION AND RISK SPREADING WITH ADVERSE SELECTION

Domar and Musgrave (1944) showed that taxing the return from risky inv estments may encourage risk taking. The effect has come under attack a s being one of partial analysis that would disappear in general equili brium. This paper shows that the contrary is true if capital markets s uffer from adverse selection. Asymmetric information induces investors to bear risk that could be spread in the capital market. The tendency to such behaviour may be increased by a tax on risky capital income. In that case, social risk spreading decreases, while the opposite effe ct would hold if general equilibrium repercussions were ignored.