Taxation of Labor Income and the Demand for Risky Assets

This article analyzes the effect of labor income risk on the joint saving/portfolio‐composition problem. Given decreasing absolute prudence, we find that even when labor income risk increases overall saving, it tends to lower investment in a risky asset. Applying the theory to public finance, we argue that realistic increases in marginal tax rates on labor can cause large enough reductions in after‐tax labor income risk to cause significant increases in risky investment.