Taxes and Risk in Financial Markets: A Separation Result

Abstract

Two important factors in determining how investors select portfolios and how asset prices and returns are determined are taxes and risk. Absent risk, the effect of taxes has been captured by models that assume the existence of tax clienteles and characterize implicit taxes contained in the equilibrium returns of securities as a consequence of arbitrage by marginal clienteles. Absent taxes, the effect of risk has been captured by models in which arbitrage by risk averse investors leads to risk premia linearly related to economy-wide risk factors. When both risk and taxes are present, they interact in complex ways that eliminate the clean results obtainable when each characteristic is considered in isolation. The purpose of this paper is to demonstrate that the effects of taxes and risk on asset prices and returns can be linearly separated under the realistic assumption that there exists a parsimonious set of index futures contracts that spans the non-diversifiable risk factors in asset prices. The key implication of this separation is that under relatively weak assumptions, researchers can validly consider either taxes or risk in isolation, as if the other does not exist.