AN ANALYSIS OF THE EFFECT OF TAX LAW INSTABILITY AND PREFERENTIAL CAPITAL GAIN TREATMENT ON INVESTMENT IN RISKY ASSETS (CAPITAL GAINS)

In recent years, tax law changes have become increasingly frequent: more new tax laws were passed in the 1980's than in any previous decade. Tax law instability creates uncertainty for taxpayers regarding effective tax rates to be used for economic decision-making. Such uncertainty may reduce a taxpayer's willingness to undertake risky investment.; Preferential capital gain treatment is frequently mentioned as a means of encouraging such risky investment. Yet, the existing literature does not provide conclusive support for this viewpoint. The effects of preferential capital gain treatment and tax law instability on risky investment may also depend on the type of asset being considered.; This study examines the hypotheses that tax law instability reduces risky investment and preferential capital gain treatment increases risky investment. It also addresses the question of whether the impact of instability in the tax law and preferential capital gain treatment depends on the riskiness of the investment opportunity.; A laboratory experiment was conducted to test these hypotheses. Student subjects participated in two computerized investment games in which they allocated points between risky and riskless assets. The different tax environments were simulated by using a management fee assessed on investment earnings. The variance of the management fee was manipulated to represent tax law stability.; Subjects were also assigned to one of two conditions representing a level of taxing capital gains. Capital gains taxation was simulated by manipulating the mean management fee. A mean management fee of 15 percent on investment earnings represented preferential capital gain treatment, whereas a mean management fee of 33 percent indicated taxation of capital gains at regular rates.; The study examined two levels of risky investment. Subjects were randomly assigned to investment games where the risky asset had either a high or moderate level of risk.; Data collected from the experiment were analyzed with a randomized block design. The blocking variable was the subject's attitude toward risk. The results found instability in the tax law and preferential capital gain treatment did not significantly affect risky investment. However, the subject's attitude toward risk and the riskiness of the investment opportunity were found to influence investment decisions.