Taxation, portfolio choice, and asset returns

This dissertation analyzes the effects of specific features of the U.S. tax code on optimal portfolio choices and equilibrium asset prices. It includes three essays.;The first essay derives the effects of stochastic taxes on asset prices in a dynamic general equilibrium model. Marginal income tax rates in the U.S. have fluctuated considerably since federal income taxes were introduced. Whenever taxes change, bond and equity prices adjust to clear the asset markets. These price adjustments affect assets with long durations, such as equities and long-term bonds, more than short-term assets. Under plausible conditions, investors require higher equity and term premia as compensation for the risk introduced by time-varying taxes.;The second essay derives optimal portfolio choices for investors who can hold assets in both taxable and tax-deferred savings accounts. Although the allocation of assets among different asset classes has received considerable attention, investors have not been given much guidance about which assets should be located in tax-deferred and which in taxable accounts. This essay analyzes first the taxation of returns of stocks, taxable corporate bonds, and tax-exempt municipal bonds held in both types of accounts. Optimal asset allocations (which assets to hold) and asset locations (in which accounts to hold them) are then computed for a risk-averse investor saving for retirement. Locating assets optimally can significantly improve the risk-adjusted performance of a portfolio.;The third essay studies tax externalities of open-end equity mutual funds. Investors holding mutual funds in taxable accounts face a classic externality: the after-tax return of their investment depends on the behavior of others. Investors redeeming or buying mutual fund shares affect the after-tax returns of the other mutual fund shareholders by accelerating or deferring their capital gains taxes. The simulations indicate that these externalities are important determinants of the after-tax performance of equity mutual funds. Mutual fund managers can mitigate or exacerbate these externalities by choosing different investment and accounting policies.