Are Taxes and Risk Substitutional or Complementary Determinants of Entrepreneurial Investment Policy?

This paper analyzes the impact of taxation on risk-taking under irreversibility. We integrate a simple tax system into a real option model. Under irreversibility and risk neutrality, raising the tax rate can either increase or reduce risk-taking. We numerically derive tax-volatility indifference curves, i.e. combinations of volatility and tax rate, which induce identical investment thresholds. Using this novel illustration technique it is possible to identify conditions for an unambiguous influence of taxes on risk-taking. Our simulations indicate that raising the tax rate increases risk-taking under low volatility. Implementing a final withholding tax on capital income tends to reduce risky investment. Our findings extend the well-known tax effects on investment from certainty with respect to uncertainty, irreversibility, and risk-taking.