Capital Market Equilibrium with Differential Taxation

Suleyman Basak and Michael Gallmeyer

Review of Finance, 2003, vol. 7, issue 2, 121-159

Abstract: This paper studies the effect of investor-specific differential dividend taxation on the dynamics of equilibrium security prices and allocations. In order to deal with the inherent Pareto inefficiency of such an equilibrium as well as the preclusion of tax arbitrage, we construct a continuous-time equilibrium via a representative investor with state-dependent utility. Investors differ in their pricing of risk, inducing investor-specific consumption-based CAPMs, with differential taxation appearing as an additional factor. The interest rate, stock price, and consumption dynamics are also impacted. Under logarithmic preferences, risk is transferred from the higher-taxed to the lower-taxed investor, and the interest rate decreases to counteract extra precautionary savings against this suboptimally shared risk. Numerical analysis reveals further tax rate, time-to-horizon, and dividend risk effects on equilibrium quantities. For most wealth allocations, the stock return volatility is increased above the no-tax benchmark. JEL classification codes: G10, G12, D51, D58, H20

Date: 2003
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