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An Equilibrium Model of Asset Pricing with Progressive Personal Taxes

Published online by Cambridge University Press:  06 April 2009

Tsong-Yue Lai
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Abstract

This paper examines how the progressive personal tax rate affects the equilibrium asset pricing model. In a continuous-time framework with progressive taxation, it can be shown that the expected excess rate of return on a risky asset is an increasing function of (i) the covariance of asset return with aggregate consumption rate changes, and (ii) the covariance of asset return with the aggregation of individual wealth change, weighted by the investor's tax scheme progressivity index. The capital asset pricing model derived in the absence of tax is shown to understate the expected excess rate of return and to have a misspecification error under the progressive tax scheme. Furthermore, the expected excess rate of return can be decomposed as the consumption risk premium and tax premium. The tax premium depends on the tax structure prevailing in the economy.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 24 , Issue 1 , March 1989 , pp. 117 - 127
Copyright
Copyright © School of Business Administration, University of Washington 1989

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