Taxation and Asset Pricing in a Production Economy: Working Paper 2008-10

Working Paper
November 25, 2008

Maria I. Marika Santoro and Chao D. Wei

This paper studies the asset pricing implications of dividend and corporate income taxes in a stochastic general equilibrium model with production similar to Jermann (1998). In particular, we ask whether those two types of taxes introduce additional tax-related risk factors in the economy, and how the equity premium may be affected. We find that proportional dividend taxes introduce no additional risk factors and, as a result, have no impact on the equity premium. By contrast, corporate income taxes have strong implications for asset pricing. Key economic variables, including consumption, dividends, and investment, are more volatile in a general equilibrium model with corporate income taxes. Thus, a larger equity premium is required to compensate for the risk brought about by such taxes.