HOW TAXES AFFECT MARKET PRICE: THE "LONGS AND SHORTS" OF DISCOUNTING AND INFORMATION

Abstract

In one-period competitive equilibrium with risk-neutral traders, no discounting of money, and perfect information, the actual value of the marginal tax rate on capital gains from either "long" or "short" asset positions has no direct impact on market price. This is because the government shares in a trader's net losses to the same extent that it shares in the same trader's net gains, with exactly offsetting effects on the trader's expected utility. However, similar results do not necessarily hold for markets in which (1) money is discounted, and/or (2) individual traders possess private information about the intrinsic value of the asset's price. In this article, we study the effects of tax-rate changes on asset price in several one-period markets with different assumptions regarding discounting and private information. To investigate the interactions of these two effects as they apply to taxes on long-term capital gains, we construct a multi-period Markov chain to capture the behavior of traders with long or short positions in a market with both discounting and (randomly injected) private information. This model shows that, in equilibrium, an increase in the marginal tax rate on long-term capital gains from either long or short positions tends to dampen market price, with a greater impact in the case of capital gains from short positions.