Stochastic taxation and asset pricing in dynamic general equilibrium

Tax rates have fluctuated considerably since federal income taxes were introduced in the U.S. in 1913. This paper analyzes the effects of stochastic taxation on asset prices in a dynamic general equilibrium model. Stochastic taxation affects the after-tax returns of both risky and safe assets. Whenever taxes change, bond and equity prices adjust to clear the asset markets. These price adjustments affect assets with long durations, such as equities and long-term bonds, more than short-term assets. Under plausible conditions, investors require higher term and equity premia as compensation for the risk introduced by tax changes. (c) 2005 Elsevier B.V. All rights reserved.