Nonlinear Taxation, Tax Arbitrage and Equilibrium Asset Prices.pdf

Nonlinear Taxation, Tax Arbitrage and Equilibrium Asset Prices Suleyman Basak Benjamin Croitoru Finance Department Finance Department The Wharton School The Wharton School University of Pennsylvania University of Pennsylvania Philadelphia, PA 19104-6367 Philadelphia, PA 19104-6367 Tel: (215) 898-6087 Tel: (215) 557-9426 Fax: (215) 898-6200 Fax: (215) 557-9426 basaks@wharton.upenn.edu croito32@wharton.upenn.edu This revision: February 1999 Nonlinear Taxation, Tax Arbitrage and Equilibrium Asset Prices Abstract This paper investigates the equilibrium implications of the presence of nonlinearly taxed, redun- dant 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 e®ectively 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 ¯nancial inno- vation 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 e®ects arise, where one agent holds the aggregate supply of each risky security, and only the bond is traded across agents. Clientele e®ects are shown to arise when agents tax rates are highly heterogeneous and when t