Non-linear taxation, tax-arbitrage and equilibrium asset prices

Abstract

This paper investigates the equilibrium implications of the presence of non-linearly 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.