Tax Risk and Asset Prices: Evidence from Dual-class Corporate Bonds in the Early 19th Century

Abstract

This paper exploits a natural experiment from the late 1800s in which many U.S. firms had inadvertently issued both taxable and tax-exempt bonds. Investors paid income tax on taxable bonds, but firms covered income tax on investors' behalf on tax-exempt bonds. Using a unique data-set of these `dual-class' corporate bonds, we derive a novel, market-based measure for tax risk, examine its time-series properties, and investigate if tax risk is priced in asset returns. We find that tax risk is pro-cyclical, is priced in the cross-section of asset returns, and commands a statistically and economically significant positive risk premium.

Keywords: Tax, Tax risk, Asset prices, Cross-section of returns

JEL Classification: G10, G12, G13, G18, H22, H24, N21, N22, H71