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Capital Market Equilibrium with Differential Taxation
Authors:Suleyman Basak and Michael Gallmeyer
Affiliation:(1) Institute of Finance and Accounting, London Business School and CEPR, Regent's Park, London, NW1 4SA, United Kingdom;(2) Graduate School of Industrial Administration and Center for Computational Finance, Carnegie Mellon University, Tech and Frew Streets, Pittsburgh, PA, 15213-3890, United States
Abstract:This paper studies the effect of investor-specific differentialdividend taxation on the dynamics of equilibrium security pricesand allocations. In order to deal with the inherent Paretoinefficiency of such an equilibrium as well as the preclusion oftax arbitrage, we construct a continuous-time equilibrium via arepresentative investor with state-dependent utility. Investorsdiffer in their pricing of risk, inducing investor-specificconsumption-based CAPMs, with differential taxation appearing asan additional factor. The interest rate, stock price, andconsumption dynamics are also impacted. Under logarithmicpreferences, risk is transferred from the higher-taxed to thelower-taxed investor, and the interest rate decreases tocounteract extra precautionary savings against this suboptimallyshared risk. Numerical analysis reveals further tax rate,time-to-horizon, and dividend risk effects on equilibriumquantities. For most wealth allocations, the stock returnvolatility is increased above the no-tax benchmark.
Keywords:differential taxation  equilibrium asset pricing  tax arbitrage  stock volatility
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