The Domar-Musgrave phenomenon and adverse selection

Abstract

The taxation of risk-taking revenues induces an investor, who allocates a given amount of resources between a risky and a safe asset, to increase the risky share of his portfolio. This result was first derived by Domar and Musgrave in a partial analytic framework. In a more general framework it has been shown that, given that all tax revenues are redistributed in a lump-sum fashion, this Domar-Musgrave phenomenon can be expected to show up only if a substantial diversification of risks takes place within the tax proceeds. Given perfect capital markets, however, such "insurance"-properties of risk-taking-revenue taxes cannot be expected to exist. Is the Domar-Musgrave pheonomenon only a partial analytic peculiarity without much inportance? In this paper it is tried to revaluate the Domar-Musgrave phenomenon. Asymmetric information, in particular with regard to the valuation of entre-preneural firms that are considering going public, may induce a process of adverse selection. Some entrepreneurs decide not to go public or they sell only some part of their firms. In equilibrium, therefore, some unsystematic risk remains uncon­ solidated. In this case "compulsory insurance" such as a risk-taking-revenue tax is not ineffective. An additional risk consolidation takes place within the collected tax proceeds. However, the impact of such taxes on welfare is quite diverse, depending on the abilities of the owners of taxed entrepreneural firms to react to the taxes. If owners of entrepreneural firms cannot react via a change of ownership structure, then they will react like the investor in the portfolio model of the Domar-Musgrave framework, reproducing the effects derived in this literature. Good examples of this type of firm may be small business firms and craftsmen. However, if the original owner-managers of firms go public with a strictly positive percentage of their firms, while keeping a fraction of their own firms in their portfolios, the risk-taking-revenue tax induces them to increase this fraction. In this case the tax reinforces the process of adverse selection. The impact of a risk-taking-revenue tax on welfare depends on the type of firm. (author's abstract)