Finance and Economics Discussion Series (FEDS)
July 1997
Taxation of Labor Income and the Demand for Risky Assets
Douglas W. Elmendorf and Miles S. Kimball
Abstract:
We analyze the effect of labor income risk on the joint saving/portfolio-composition problem. It is well known that when private insurance markets are incomplete, the insurance afforded by labor income taxes can reduce overall saving through the precautionary saving motive. This insurance may change the composition of saving as well, because the reduction in labor income risk may affect the amount of financial risk that an individual chooses to bear. We find that, given plausible restrictions on preferences, any change in taxes that reduces an individual's labor income risk and does not make her worse off will lead her to invest more in risky assets. This result holds even when labor income is statistically independent of the return to risky assets. We also find that the effect of labor income risk on financial risk-taking can be quantitatively important for realistic changes in tax rates.
Keywords: Taxation, saving, uncertainty
PDF: Full Paper
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