The Social Cost of Federal Financing 123 



There are other reasons for adhering to our model's assumption. 

 First, the empirical evidence on the relationship between risk- 

 taking and individual welfare is scanty and unconvincing. While 

 people purchase insurance to reduce risk, they also gamble.*^ 

 Second, and more important, there are two very strong institutional 

 factors in our economy which erode the relationship between high 

 risk and high return. One is the giant corporation which under- 

 takes so many investments that there is much pooling of risks 

 within its own program. The suppliers of the corporation's capital 

 bear only a fraction of the sum of risks of the individual invest- 

 ment projects, and the same is true of the company itself. The 

 other institutional factor is our tax system, which makes risky 

 investments particularly attractive to wealthy individuals, since 

 they usually lead to capital gains rather than ordinary income. 

 With much the largest part of the investable funds made available 

 by personal sources *^ coming from taxpayers in the upper brackets, 

 the differential between tax rates on capital gains and on ordinary 

 income promotes the willingness to take risks to such an extent that 

 the difference between the rates of return of risky and secure 

 investments must be much diminished. 



Let us briefly consider the cost of capital if risk premiums are 

 treated as prices paid for the factor service of risk-bearing. Lenders 

 are assumed to be rational in this respect, and the risk premium of 

 a loan must be sufficient to compensate for the risk which is taken. 

 On this assumption, a federal loan which displaces a risky private 

 loan and invests the proceeds in a risk-free project would entail 

 a lower social cost than the alternative since there is a reduction 

 in risk-bearing. If we make the bold assumption that all differ- 

 ences in interest rates for the same period are risk premiums, then 

 it might be argued that the true social cost of a risk-free federal 

 investment is the pure interest rate alone — a rate which is prob- 

 ably best approximated by the yield on federal securities with a 

 term equal to the life of the investment. 



** Cf. M. Friedman and L. J. Savage, "The Utility Analysis of Choices Involv- 

 ing Risk," Journal of Political Economy, August 1948, pp. 279-304; and F. 

 Mosteller and P. Nogce, "An Experimental Measurement of Utility," ibid., 

 October 1951, pp. 371-405. 



"For a full discussion of this point, .see J. K. Hutters, L. E. Thompson, and 

 L. L. Bollinger, Effects of Taxation, Investment by Individuals, (Boston: Gradu- 



