1 Portfolio choice

Two states of the world: 1 good, 2 bad

Initial wealth 0
Two assets: safe asset and risky asset

Final wealth (for each euro invested)

State 1 State 2
safe asset 1+ 1+
risky asset 1 + 1 1 + 2

where 1    2
Let  the share of initial wealth invested in the risky asset. Final wealth in
the two states of the world (1  2 ) will be:

1 2
0 [(1 − ) (1 + ) +  (1 + 1 )] = 0 [(1 − ) (1 + ) +  (1 + 2 )] =
0 [(1 + ) +  (1 − )] 0 [(1 + ) +  (2 − )]

When  = 0 (all wealth invested in the safe asset)

1 2
0 (1 + ) 0 (1 + )

When  = 1 (all wealth invested in the risky asset)

1 2
0 (1 + 1 ) 0 (1 + 2 )

The budget constraint is a straight line that crosses the two points with
 = 0 and  = 1. The equation of a straight line crossing points (1  1 ) and
(2  2 ) is:
2 − 1
 = ( − 1 ) + 1 
2 − 1
By substituting the values for (1  1 ) and (2  2 ) we get:

0 (1 + 2 ) − 0 (1 + )
2 = (1 − 0 (1 + )) + 0 (1 + ) =
0 (1 + 1 ) − 0 (1 + )
2 − 
2 = (1 − 0 (1 + )) + 0 (1 + ) =
1 − 
2 −  1 − 2
2 = 1 + 0 (1 + )
1 −  1 − 

1
Assume that the consumer has preferences that can be represented by a well
behaved utility function  (1  2 ). The necessary condition for the optimum
∗ is:

2 − 
  ≡ − 

1
= ≡ slope of the budget constraint.
2
1 − 

When preferences can be represented by the expected utility

 =  (1 ) + (1 − )  (2 )

where  is the probability of state 1, the necessary condition can be written as:

1  0 (1 ) 2 − 
−  =− 0
=  (1)
2
(1 − )  (2 ) 1 − 

This condition can be used to calculate the slope of an Engel curve. Remember
that the Engel curve represents the equilibria points when wealth varies. A
move (1  2 ) along an Engel curve must satisfy the necessary condition for
an optimum. Hence, by differentiating (1):

 00 (1 )  0 (1 ) 00
− 0
1 + 2  (2 ) 2 = 0
(1 − )  (2 ) 0
(1 − ) ( (2 ))

Rearranging:

2  00 (1 )  0 (1 )

Slope of an Engel curve ≡ = 00 (2)
1  (2 )  0 (2 )

Recollect that
 00 ( )
 ( ) = −
 0 ( )
is the measure of absolute risk aversion. When absolute risk aversion is constant
 ( ) =  and

2  00 (1 )  0 (1 )  (1 ) 

= 00 = = =1
1  (2 )  0 (2 )  (2 ) 

Conclusion 1 When absolute risk aversion is constant the slope of Engel curves
is equal to one.

Notice that the slope of an Engel curve (2) can be written as

2  00 (1 )  0 (1 ) 1 2  00 (1 ) 1  0 (1 ) 2

= 00 =
1  (2 )  0 (2 ) 2 1  00 (2 ) 2  0 (2 ) 1

Recollect that
( ) =  00 ( )  0 ( )

2
is the measure of relative risk aversion. When relative risk aversion is constant
 ( ) =  and
2  00 (1 ) 1  0 (1 )  (1 ) 2  2 2
= 00 0
= = = 
1  (2 ) 2  (2 )  (2 ) 1  1 1
This implies that along an Engel curve 1 and 2 should vary in the same
proportion
2 2
= 1
1 1
which implies, in turn, that the Engel curve is a ray from the origin.

Conclusion 2 When relative risk aversion is constant all Engel curves are
straight lines through the origin, and have unitary elasticity

2 Budget constraint with taxes

Ex ante wealth tax (rate )

 = 0 [(1 + ) +  ( − )] − 0 = 0 (1 − ) [(1 + ) +  ( − )]

= 0 [(1 + ) (1 − ) +  ( − ) (1 − )]

W2

W0 W0(1-t)(1+ x1) W0(1+x1) W1

W0(1-t)(1+ r)

W0(1+r)

Ex ante wealth tax

The budget constraint is

2 −  1 − 2
2 = 1 + 0 (1 − ) (1 + ) (3)
1 −  1 − 

3
Income tax (rate  ) with full loss-offset

 = 0 [(1 + ) +  ( − )] − [  +   ( − )] 0

= 0 [(1 +  (1 −  )) +  ( − ) (1 −  )]

W2

W0 W0[1+ x1(1-)] W0(1+x1) W1

W0[1+ r (1-)]

W0(1+r)

Income tax

The budget constraint is

2 −  1 − 2
2 = 1 + 0 (1 +  (1 −  )) (4)
1 −  1 − 
Tax on the safe return (rate )

0 [(1 + ) +  ( − )] − 0

= 0 [(1 +  (1 − )) +  ( − )]

4
 W2

W0(1+ x1-r)

W0 W0(1+x1) W1
W0(1+ x1-sr)

W0[1+ r (1-s)]
W0(1+r)

Tax on the safe return

The budget constraint is

2 −  1 − 2
2 = 1 + 0 (1 +  (1 − )) (5)
1 −  1 − 
³ ´
 
If  = 1+  and  =  then (1 − ) (1 + ) = 1 − 1+  (1 + ) = 1 +
 (1 −  ) and all three budget constraints (3), (4) and (5) are equivalent.

Conclusion 3 When investors can freely adjust their portfolios at no cost, a

wealth tax, an income tax with full loss-offset and a tax on the safe return are

equivalent both ex-ante and ex-post if  =  and  = 1+  . The demand for the
risky asset increases when the tax on the safe return is replaced by a wealth tax
and when the wealth tax is replaced by the income tax.

3 Effect of taxes on the demand for the risky

asset ()
Conclusion 4 A proportional wealth tax increases, leaves unchanged, or de-
creases the demand for risky assets as the individual has increasing, constant,
or decreasing relative risk aversion

Conclusion 5 A proportional tax on the safe return increases, leaves unchanged,

or decreases the demand for risky assets as the individual has increasing, con-
stant, or decreasing absolute risk aversion

Conclusion 6 Increased income taxes with full loss-offset lead to increased de-
mand for risky assets when

5
 ( )
Decreasing Constant Increasing
Decreasing impossible impossible
 ( ) Constant x impossible impossible
Increasing x x x

References
[1] JE Stiglitz The Effects of Income, Wealth, and Capital Gains Tax-
ation on Risk-Taking, The Quarterly Journal of Economics, 1969
(https://cowles.econ.yale.edu/P/cp/p02b/p0293.pdf)