In this paper we explore what happens if the government bears some ofthe risk through a profit tax when the risk sharing in the venture capitalmarket is incomplete due to non-observability of effort and moral hazard. Ifthe external equity investors can enforce exclusive contracts with the entrepreneurs,the risk relief through a profit tax will give too much insuranceand too low effort compared with a second best optimal solution. Bond &Devereux (1995) show that a proportional profit tax would be actuariallyneutral in the absence of moral hazard. In the presence of moral hazard wedemonstrate that the tax may affect the risk shifting through the market,in which case the premise for the neutrality result will no longer hold. Wealso find that in contrast to exclusive risk sharing contracts non-exclusivecontracts may in conjunction with a proportional profit tax lead to too little provision of effort.
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