A Dynamic Partial Equilibrium Model of Capital Gains Taxation

We analyze a multi-period partial equilibrium model with capital gains taxation. Relative to an economy without taxation, a capital gains tax tends to lower prices and raise expected returns, but it has little effect on volatility. Abstracting from tax redistribution policies, we find that a taxable investor’s welfare falls, a nontaxable investor’s welfare rises, and, depending on the tax rate, social welfare may either rise or fall under a capital gains tax. Furthermore, the taxable investor’s tax-timing option may either increase or decrease tax revenue. Implications for empirical asset pricing are identified. ∗Smeal College of Business, Pennsylvania State University, University Park, PA, 16802; 814-867-5795; slenkey@psu.edu. †Smeal College of Business, Pennsylvania State University, University Park, PA, 16802; 814-865-3457; tts3@psu.edu.