Auditing, Professional Judgement, Expected utility framework

The mean-variance capital asset pricing model (CAPM) of Sharpe and Lintner was extended by Brennan [3] to incorporate divergent borrowing and lending rates. He found that in equilibrium the security market line (SML) has the same structure as the SML under the single-rate CAPM of Sharpe and Lintner. That is, the expected return of a security or a portfolio remains linear in its systematic risk, with the intercept replaced by an equivalent risk-free return, which is an average of the divergent borrowing and lending rates weighted by the investors' taste parameters. The equivalent risk-free return is larger than the riskless lending rate and, hence, does not represent an inconsistency with the empirical findings by Friend and Blume [4] and by Black, Jensen and Scholes [1[ that the intercept of empirical SML estimated for the single-rate CAPM is larger than the riskless rate. Moreover, Brennan attempted to show that his construct can be extended to the extreme case where there are no riskless opportunities. The case of no riskless opportunities was of course investigated by Black [2], who generalized the CAPM and SML by inventing the concept of zero-beta port-folio to account for the same empirical problem encountered in the traditional SML tests of CAPM. Since the Sharpe-Lintner single-riskless-rate CAPM implies a perfect loan market, we may view the attempts by Black and Brennan as generalizing the CAPM by incorporating financial restrictions and loan market imperfections. Their primary motive, however, is empirical, i.e., to reconcile the results from the traditional SML tests with their generalized CAPM.

Although an income tax is often a government's most important instrument for raising revenue and redistributing income, its potential usefulness for either of these purposes is limited by its negative impact on work incentives. The implications of the incentive effect have been studied by examining optimal tax structures under a variety of assumptions about preferences, the distribution of wage rates, and the form of the social welfare function. Much of this work has been done using models that include interpersonal variation in ability (wage rates), but in which no saving or dissaving occurs, i.e. in which the consumption of each individual is exactly equal to his labour income net of taxes within the time period (Mirrlees (1971), Sheshinski (1972a), (1972b), Atkinson (1973a), (1973b), Phelps (1973), Cooter and Helpman (1974), Itsumi (1974), Sadka (1976)). While the latter assumption might be innocuous if wage rates were approximately constant over an individual's lifetime, so that there was little incentive to borrow or save, or if capital markets were non-existent, so that borrowing and saving were impossible, wage profiles are in fact quite steep and most individuals make use of (admittedly imperfect) capital markets. Multiperiod models incorporating consumption-saving decisions have been used to study the effects on capital accumulation of wage, interest, capital gains, and other taxes, but even those models that include variation in ability have in general assumed that labour is supplied at a constant rate over the individual's working years (Ordover and Phelps (1975), Sheshinski (1976), Feldstein (1974)). A life-cycle model of individual behaviour that includes both labour supply and consumption decisions is used below. Although a general equilibrium framework is used, for simplicity real capital is ignored; labour is the only factor of production and government debt is the only asset available to savers. Only steady states and only linear tax schedules are considered, and the utilitarian social welfare function is used throughout. First, the conditions under which the life-cycle model reduces to the one-period case are derived, as well as the conditions under which the first-best tax policies for the two are identical. Next it is shown that if all individuals are identical, the optimal policy consists of lump-sum taxes together with an interest rate equal to the rate of pure time preference. The non-optimality of the biological interest rate proposed by Samuelson (1958) in his Exact Consumption-Loan Model is discussed. Finally, an upper bound on the optimal marginal tax rate is derived. This bound depends on the elasticity of total labour supply and on the elasticity of demand for debt.

Journal Article Vertical and Horizontal Communication in Economic Processes Get access Robert L. Welch Robert L. Welch University of Kentucky Search for other works by this author on: Oxford Academic Google Scholar The Review of Economic Studies, Volume 47, Issue 4, July 1980, Pages 733–746, https://doi.org/10.2307/2296939 Published: 01 July 1980 Article history Received: 01 July 1976 Received: 01 September 1979 Published: 01 July 1980