I develop an analytically tractable model that integrates the risk-shifting problem between bondholders and shareholders with the moral-hazard problem between shareholders and the manager. An optimal contract binds shareholders and the manager, and this contract’s flexibility allows shareholders to relax the manager’s incentive constraint following a “good” profitability shock. Thus, the optimal contract amplifies the upside and thereby increases shareholder appetite for risk shifting. Whereas some empirical studies find a positive relation between risk shifting and leverage, others find a negative relation. This model predicts a non-monotonic relation between risk shifting and leverage and can reconcile these contradictory empirical findings.

We demonstrate that investment income taxes incentivize capital allocation to the ecofriendly green sector away from the non-ecofriendly brown sector in a stylized economy. This tax reduces the arrival intensity of climate disasters, delivers the socially optimal allocation, and can be jointly implemented with a carbon tax, expanding policymakers’ toolkit to reduce climate disasters. Extending the model with heterogeneous investors, we show that investment income taxes can obtain support from a political majority and thereby relax political constraints faced by a carbon tax alone.