Risk-spreading properties of common tax and contract instruments

Abstract

Many tax systems require payment by means of fixed fees, percentages of gross revenues (royalties or ad valorem taxes), or percentages of net income (profit shares or income taxes). Even when payments due under such instruments have the same expected value, their risk-spreading properties may differ. For equal expected levies, profit-sharing is often ranked as the most effective means of risk-spreading, followed by royalty payments, and finally by fixed fees. When revenues and costs are both uncertain, however, we demonstrate that this common risk-ranking is not generally valid and discuss reasons for its breakdown.