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Taxation and Transaction Costs in a General Equilibrium Asset Economy

Author

Listed:
  • Frank Milne

    () (Queen's University)

  • Xing Jin

    () (University of Warwick)

Abstract

Most financial asset pricing models assume frictionless, competitive markets that imply the absence of arbitrage opportunities. Given the absence of arbitrage opportunities and complete asset markets, there exists a unique martingale measure that implies martingale pricing formulae and replicating asset portfolios. In incomplete markets, or markets with transaction costs, these results must be modified to admit non-unique measures and the possibility of imperfectly replicating portfolios. Similar difficulties arise in markets with taxation. Some theoretical research has argued that some taxation functions will imply arbitrage opportunities and the non-existence of a competitive asset economy. In this paper, we construct a multi-period, discrete time/state general equilibrium model of asset markets with transaction costs and taxes. The transaction cost technology and the tax system are quite general, so that we can include most discrete time/state models with transaction costs and taxation. We show that a competitive equilibrium exists. Our results require careful modeling of the government budget constraints to rule out tax arbitrage possibilities.

Suggested Citation

  • Frank Milne & Xing Jin, 2006. "Taxation and Transaction Costs in a General Equilibrium Asset Economy," Working Papers 1111, Queen's University, Department of Economics.
    • Handle: RePEc:qed:wpaper:1111
    as

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    File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1111.pdf
    File Function: First version 2006
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    References listed on IDEAS

    as
    1. Zechner, Josef, 1990. "Tax Clienteles and Optimal Capital Structure under Uncertainty," The Journal of Business, University of Chicago Press, vol. 63(4), pages 465-491, October.
    2. Dybvig, Philip H & Ross, Stephen A, 1986. " Tax Clienteles and Asset Pricing," Journal of Finance, American Finance Association, vol. 41(3), pages 751-762, July.
    3. Ross, Stephen A, 1987. "Arbitrage and Martingales with Taxation," Journal of Political Economy, University of Chicago Press, vol. 95(2), pages 371-393, April.
    4. Frank Milne & Edwin Neave, 2003. "A General Equilibrium Financial Asset Economy with Transaction Costs and Trading Constraints," Working Papers 1082, Queen's University, Department of Economics.
    5. Jérôme B. Detemple & Shashidhar Murthy, 1997. "Equilibrium Asset Prices and No-Arbitrage with Portfolio Constraints," CIRANO Working Papers 97s-12, CIRANO.
    6. Xing Jin & Frank Milne, 1999. "The Existence Of Equilibrium In A Financial Market With Transaction Costs," World Scientific Book Chapters,in: Quantitative Analysis In Financial Markets Collected Papers of the New York University Mathematical Finance Seminar, chapter 14, pages 323-343 World Scientific Publishing Co. Pte. Ltd..
    7. Duffie, Darrell, 1987. "Stochastic equilibria with incomplete financial markets," Journal of Economic Theory, Elsevier, vol. 41(2), pages 405-416, April.
    8. Dammon, Robert M & Green, Richard C, 1987. " Tax Arbitrage and the Existence of Equilibrium Prices for Financial Assets," Journal of Finance, American Finance Association, vol. 42(5), pages 1143-1166, December.
    9. Detemple, Jerome & Murthy, Shashidhar, 1997. "Equilibrium Asset Prices and No-Arbitrage with Portfolio Constraints," Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 1133-1174.
    10. Domenico Cuoco & Hong Liu, 2000. "A Martingale Characterization of Consumption Choices and Hedging Costs with Margin Requirements," Mathematical Finance, Wiley Blackwell, vol. 10(3), pages 355-385.
    11. Constantinides, George M, 1983. "Capital Market Equilibrium with Personal Tax," Econometrica, Econometric Society, vol. 51(3), pages 611-636, May.
    12. Green, Richard C, 1993. "A Simple Model of the Taxable and Tax-Exempt Yield Curves," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 233-264.
    13. Kelsey, David & Milne, Frank, 1996. "The existence of equilibrium in incomplete markets and the objective function of the firm," Journal of Mathematical Economics, Elsevier, vol. 25(2), pages 229-245.
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    More about this item

    Keywords

    Taxation; Transaction Costs; General Equilibrium; Asset Economy;

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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