Capital Market Equilibrium with Differential Taxation

Abstract:     
This paper studies the dynamics of equilibrium security prices when agents face differential dividend taxation. We construct a continuous-time equilibrium via a representative agent with stochastic weights. Agents differ in their pricing of risk inducing agent-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 agent, 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. For most wealth allocations, the stock return volatility is increased above the no-tax benchmark.

JEL Classifications: G12

Working Paper Series