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Taxes, regulations, and asset prices

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  • Ellen R. McGrattan
  • Edward C. Prescott

Abstract

U.S. stock prices have increased much faster than gross domestic product GDP) in the postwar period. Between 1962 and 2000, corporate equity value relative to GDP nearly doubled. In this paper, we determine what standard growth theory says the equity value should be in 1962 and 2000, the two years for which our steady-state assumption is a reasonable one. We find that the actual valuations were close to the theoretical predictions in both years. The reason for the large run-up in equity value relative to GDP is that the average tax rate on dividends fell dramatically between 1962 and 2000. We also find that, given legal constraints that effectively prohibited the holding of stocks as reserves for pension plans, there is no equity premium puzzle in the postwar period. The average returns on debt and equity are as theory predicts.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Minneapolis in its series Working Papers with number 610.

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Date of creation: 2001
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Publication status: Published in Federal Reserve Bank of Minneapolis Staff Report 309
Handle: RePEc:fip:fedmwp:610

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Keywords: Asset pricing ; Taxation ; Regulation;

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References

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  1. Auerbach, Alan J, 1979. "Wealth Maximization and the Cost of Capital," The Quarterly Journal of Economics, MIT Press, vol. 93(3), pages 433-46, August.
  2. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 01-90, Wharton School Rodney L. White Center for Financial Research.
  3. Kurz, M. & Beltratti, A., 1996. "The Equity Premium Is No Puzzle," Papers 282, Banca Italia - Servizio di Studi.
  4. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1995. "Asset pricing lessons for modeling business cycles," Working Paper Series, Macroeconomic Issues 95-11, Federal Reserve Bank of Chicago.
  5. Martin Feldstein, 1979. "Inflation, Tax Rules, and the Stock Market," NBER Working Papers 0403, National Bureau of Economic Research, Inc.
  6. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  7. Lawrence H. Summers, 1981. "Taxation and Corporate Investment: A q-Theory Approach," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 12(1), pages 67-140.
  8. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June.
  9. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-86, April.
  10. Robert E. Hall, 2000. "The stock market and capital accumulation," Proceedings, Federal Reserve Bank of San Francisco, issue Apr.
  11. George M. Constantinidies & John B. Donaldson & Rajnish Mehra, 1998. "Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle," NBER Working Papers 6617, National Bureau of Economic Research, Inc.
  12. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  13. Martin Feldstein & Jerry Green, 1979. "Why Do Companies Pay Dividends?," NBER Working Papers 0413, National Bureau of Economic Research, Inc.
  14. Martin Feldstein, 1983. "Inflation and the Stock Market," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 186-198 National Bureau of Economic Research, Inc.
  15. John Y. Campbell & Robert J. Shiller, 2001. "Valuation Ratios and the Long-Run Stock Market Outlook: An Update," NBER Working Papers 8221, National Bureau of Economic Research, Inc.
  16. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  17. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  18. James M. Poterba & Lawrence H. Summers, 1985. "The Economic Effects of Dividend Taxation," NBER Working Papers 1353, National Bureau of Economic Research, Inc.
  19. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  20. Fernando Alvarez & Urban J. Jermann, 1999. "Quantitative asset pricing implications of endogenous solvency constraints," Working Papers 99-5, Federal Reserve Bank of Philadelphia.
  21. Ellen R. McGrattan & Edward C. Prescott, 2001. "Is the Stock Market Overvalued?," NBER Working Papers 8077, National Bureau of Economic Research, Inc.
  22. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  23. Hansen, Lars Peter & Sargent, Thomas J & Tallarini, Thomas D, Jr, 1999. "Robust Permanent Income and Pricing," Review of Economic Studies, Wiley Blackwell, vol. 66(4), pages 873-907, October.
  24. John H. Cochrane, 1988. "Production Based Asset Pricing," NBER Working Papers 2776, National Bureau of Economic Research, Inc.
  25. Gali, J., 1992. "Keeping Up with the Joneses: Consumption Externalities, Portfolio Choice and Asset Prices," Papers 92-22, Columbia - Graduate School of Business.
  26. Bansal, Ravi & Coleman, Wilbur John, II, 1996. "A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1135-71, December.
  27. Cochrane, John H, 1991. " Production-Based Asset Pricing and the Link between Stock Returns and Economic Fluctuations," Journal of Finance, American Finance Association, vol. 46(1), pages 209-37, March.
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