Taxation of uncertain business profits, private risk markets and optimal allocation of risk

In this paper we explore what happens if the government bears some of the risk through a profit tax when the risk sharing in the venture capital market is incomplete due to non-observability of effort and moral hazard. If the external equity investors can enforce exclusive contracts with the entrepreneurs, the risk relief through a profit tax will lead to too much insurance and too low effort as compared with a second best optimal solution. Bond and Devereux [Bond, S.R. and Devereux, M.P. (1995). On the design of a neutral business tax under uncertainty. Journal of Public economics, 58, 57–71.] show that a proportional profit tax would be neutral in the absence of moral hazard. In the presence of moral hazard we demonstrate that the tax may affect the risk shifting through the market, in which case the premise for the neutrality result will no longer hold.