The Effects of Differential Taxation on Managerial Effort and Risk Taking

Differential taxation implies the existence of different tax rates or tax bases for different types of investments. We analyze the effects of differential taxation on managerial effort and risk taking in a moral-hazard model of the LEN type. The agent selects a portfolio of a high-risk and a low-risk project and chooses his effort level simultaneously. The principal anticipates the agent's choice and offers an incentive contract. A preferential tax base for the high-risk project induces a higher managerial effort and a higher optimal fraction of the high-risk project. A preferential tax rate increases or decreases the fraction of the high-risk project, depending on the agent's degree of risk aversion.