Capital Gains Taxes and Risk

I'm not an expert in taxes (!) but I think it would be true to say that the tax treatment of capital gains and capital losses is asymmetric.  Though there are some exceptions (e.g., when gains and losses can be counter-posed to offset each other), generally speaking, if you get a 50% return on your investment, you have to pay taxes on that, but if you take a 50% loss, you don't get a reverse tax from the government to offset that (unless you get a bailout, but that takes special political intervention rather than the normal operation of the tax code).

This has an effect on risk.  For example, suppose you have a choice between two investments.  Investment A experiences a capital gain of 100% in the Good Scenario, but -50% in the Bad Scenario.  Each scenario occurs with a 50% probability.  Investment B pays a 10% return.  The investor is risk-neutral.

First, suppose there are no capital gains taxes.  The expected return on investment is the average of 100% and -50%, or 25%.  This is more than 10%, so the investor prefers Investment A.

Now, suppose a capital gains tax of 50% is imposed.  If the investor chooses Investment A, in the Good Scenario, he will have to surrender half his gains.  So his expected after-tax return is 50% + (-50%) / 2 = 0%.  If he chooses Investment B, he has to surrender half his gains, too, so his expected return is 10% / 2 = 5%.  The investor now prefers Investment B.

Expected future capital gains taxes have surely risen in the past few months.  As the example shows, the effect of capital gains taxes is to induce quasi-risk-averse behavior (even if fundamental risk aversion in individual utility functions remains the same) and encourage a "flight to safety."  Of course, bailouts have the opposite effect: if the investor can look forward to the upside while the taxpayer takes the downside, investors, or at any rate those who are politically positioned so as to be likely beneficiaries of bailouts, have incentives to take more risk, as long as they can mask it enough to stay within whatever laws may be applicable.