Limited Liability, Asymmetric Taxation, and Risk Taking — Why Partial Tax Neutralities Can Be Harmful

We examine the combined effects of asymmetric taxation and limited liability on optimal risk taking of investors. Given an optimal risk level in the no-tax case under full liability, loss-offset restrictions reduce, and limited liability increases, the incentives for taking risk. For every degree of limited liability we find corresponding loss-offset limitations inducing the same optimal risk level as in the reference case. In our model, full liability requires symmetric taxation, and limited liability requires asymmetric taxation of profits and losses. Tax effects under risk aversion are similar to those under risk neutrality.