Nonlinear Taxation, Tax Arbitrage and Equilibrium Asset Prices

Rodney L. White Center for Financial Research Working Paper No. 07-99

Posted: 16 Apr 1999

See all articles by Benjamin Croitoru

Benjamin Croitoru

McGill University - Desautels Faculty of Management

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Abstract

This paper investigates the equilibrium implications of the presence of nonlinearly taxed, redundant securities, and of the resulting tax arbitrage opportunities. Heterogeneity in taxation leads to discrepancies in assets' pre-tax market prices of risk. We show that this mispricing is set so that agents effectively cooperate to minimize aggregate taxes, even though individually each agent may not minimize his own tax bill. Unlike the bulk of the existing tax arbitrage literature, but consistent with empirical evidence, equilibrium in our model allows discrepancy between agents' marginal tax rates. Equilibrium with a zero net supply derivative reveals financial innovation to alleviate taxation, in particular when the derivative is taxed linearly or is taxed less heterogeneously across agents than is the stock itself. In the presence of two redundant, positive supply securities, clientele effects arise, where one agent holds the aggregate supply of each risky security and only the bond is traded across agents. Clientele effects are shown to arise when agents' tax rates are highly heterogeneous and when the aggregate wealth is divided fairly evenly across agents.

JEL Classification: G12, H21

Suggested Citation

Croitoru, Benjamin and Basak, Suleyman, Nonlinear Taxation, Tax Arbitrage and Equilibrium Asset Prices. Rodney L. White Center for Financial Research Working Paper No. 07-99. Available at SSRN: https://ssrn.com/abstract=159267

Benjamin Croitoru

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
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Suleyman Basak (Contact Author)

London Business School ( email )

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London, London NW1 4SA
United Kingdom
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44 (0)20 7000 8201 (Fax)

HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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