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Taxation and Bond Market Equilibrium in a World of Uncertain Future Interest Rates: Reply

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  • Livingston, Miles

Abstract

Models of security markets invariably assume that market participants act intelligently since any other assumption generally leads to absurd results. Schaefer's Comment makes the incorrect assumption that one market participant, namely the government, acts unintelligently by allowing investors to reap tax arbitrage profits. Consequently, the conclusions in the Comment are erroneous. As I will show below, a government can (and the U.S. Government does) prevent tax arbitrage and any resulting disequilibrium in the bond market through two simple tax rules. My earlier paper [1] primarily showed that bond price must be a linear function of coupon for any maturity under the assumption of constant tax brackets for all investors, and then suggested that a linear relationship will also hold with investors in different tax brackets. I will prove this last result below.

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  • Livingston, Miles, 1981. "Taxation and Bond Market Equilibrium in a World of Uncertain Future Interest Rates: Reply," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 16(5), pages 779-781, December.
    • Handle: RePEc:cup:jfinqa:v:16:y:1981:i:05:p:779-781_01
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