Arbitrage and the Tax Code
44 Pages Posted: 23 Jul 2003 Last revised: 25 Jul 2010
Date Written: July 1, 2010
Abstract
We provide a detailed characterization of arbitrage-free asset prices in the presence of capital gains and income taxes. The distinguishing feature of our analysis is that we impose on the model two important features of the tax code: the limited use of capital losses and the inability to wash sell. We show that under remarkably mild conditions, the lack of pre-tax arbitrage implies the lack of post-tax arbitrage with the limited use of capital losses. The conditions are that the risk free interest rate be positive and that tax rates on interest income exceed capital gains tax rates. The result also holds when only a wash sale constraint is imposed and no investor holds a portfolio with a large capital loss. We allow investors to face different tax rates and have different bases for the calculation of capital gains taxes. The characterizations we provide have important implications for both asset pricing and portfolio choice. Our results imply that models that use arbitrage-free pre-tax models continue for derivative pricing and hedging are also arbitrage free in a world with taxes. Similarly, portfolio choice models with taxes typically specify pre-tax arbitrage free price processes and then analyze portfolio choice in the presence of taxes. In these models, it is unclear if portfolio recommendations are based on risk-return tradeoffs or on the arbitrage opportunities present in the model. Our results imply that if the above features of the tax code are modeled explicitly, then we can isolate the post-tax risk-return tradeoffs.
Keywords: capital gain taxation, no arbitrage, tax arbitrage
JEL Classification: G11, G12, G13, H24
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Optimal Consumption and Investment with Capital Gains Taxes
By Robert M. Dammon, Harold H. Zhang, ...
-
Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing
By Robert M. Dammon, Harold H. Zhang, ...
-
Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances
-
Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances
-
The Transition to Personal Accounts and Increasing Retirement Wealth: Macro and Micro Evidence
By James M. Poterba, Steven F. Venti, ...
-
Asset Location in Tax-Deferred and Conventional Savings Accounts
By John B. Shoven and Clemens Sialm
-
Utility Evaluation of Risk in Retirement Saving Accounts
By James M. Poterba, Joshua D. Rauh, ...
-
The Location and Allocation of Assets in Pension and Conventional Savings Accounts