Capital Income Taxation and Risk-Taking under Prospect Theory: The Continuous Distribution Case

This study verifies whether the results of proportional capital income taxation on the risktaking of a loss-averse investor will still hold when the return of a risky asset has a general continuous distribution. We extend the previous literature, which assumes a binomial distribution of asset returns for a risky asset. We also show that under reasonable assumptions risk-taking is finite and positive and thus a loss-averse investor will not choose infinite leverage despite no regulations being applied. In addition, unlike in the expected utility model, the capital income tax increase does not stimulate risktaking when the reference level is the initial wealth or the gross after the tax return from
investing the initial wealth into the risk-free asset. Furthermore, when investors set their reference level at the gross (pre-tax) return from investing the initial wealth into the riskfree asset, they increase not only risk-taking but also their private risks as measured by the standard deviation of their after-tax final wealth, which is not the case in the expected utility model.