Valuing the Right to Tax Incomes : An Options Pricing Approach

This paper uses options pricing techniques to estimate the value of the government’s tax claim on household or business incomes. It treats the annual tax claim as a European call option on taxable income (a European call is an option that can be exercised at its expiration date and not before). The option’s expiration date is the end of the fiscal year and its strike price is the threshold level of income below which income is not subject to tax. The paper derives three alternative valuation formulas, each associated with an alternative functional form for the tax code (a flat tax, a step-function and a more general tax function). The application of options pricing theory to tax claims is found to be relatively straightforward. The approach proposed here could be used to refine accounting on the assets side of the government’s balance sheet. It would not be more difficult to implement than many common applications of options theory ...