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Identifying Tax Losses Entitled to Full Loss Offsets in a Business Profits Tax under the Domar-Musgrave Risk Model

An influential article by Evsey Domar and Richard Musgrave, published in 1944, argued that an efficient income tax ought to provide full loss offsets for losses suffered by investors subject to that tax. The basic argument was that by allowing full loss offsets, a tax system not only eliminated a bias against risky investments but also reduced the risk to private investors, making it more likely that they would make socially useful investments in risky ventures. In this context, a "loss offset" is an adjustment to a taxpayer's income equal to the amount of the loss multiplied by the tax rate. For example, if the tax rate is 30% and the loss is $1,000, the proper loss offset is $300. The focus of the Domar-Musgrave model is on risk. One basic contention is that an income tax without full loss offsets provides an inefficient penalty to risky investments and a concomitant bias in favor of safe investments. It follows that loss offsets, for purposes of the Domar-Musgrave model, ought to be limited to losses resulting from risky investments gone sour. Domar-Musgrave defines "risk" as the probability of the actual yield on an investment being less than zero - that is, as the probability of a loss. By this definition, all losses are due to risks gone sour. In this paper, I argue that many categories of losses do not merit a loss offset under Domar-Musgrave, properly understood. One of the categories of losses that does not warrant loss offsets is the set of losses resulting from improper tax accounting. Flawed tax account rules may themselves be inefficient by treating taxpayers able to take advantage of the flawed rules more favorably than other taxpayers with equivalent real income. Allowing full loss offsets may exacerbate the inefficiency. Losses resulting from improper tax accounting rules probably account for a substantial percentage of all corporate losses, although I have not tried to compute the percentage.