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Taxation of uncertain business profits, private risk markets and optimal allocation of risk

Hagen, Kåre Petter; Sannarnes, Jan Gaute
Working paper
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URI
http://hdl.handle.net/11250/163272
Date
2005-02
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  • Discussion papers (SAM) [638]
Abstract
In this paper we explore what happens if the government bears some of

the risk through a profit tax when the risk sharing in the venture capital

market is incomplete due to non-observability of effort and moral hazard. If

the external equity investors can enforce exclusive contracts with the entrepreneurs,

the risk relief through a profit tax will give too much insurance

and too low effort compared with a second best optimal solution. Bond &

Devereux (1995) show that a proportional profit tax would be actuarially

neutral in the absence of moral hazard. In the presence of moral hazard we

demonstrate that the tax may affect the risk shifting through the market,

in which case the premise for the neutrality result will no longer hold. We

also find that in contrast to exclusive risk sharing contracts non-exclusive

contracts may in conjunction with a proportional profit tax lead to too little provision of effort.
Publisher
Norwegian School of Economics and Business Administration. Department of Economics
Series
Discussion paper
2005:5

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