EQUILIBRIUM PRICING, TAX CLIENTELES, MARGINAL TAX RATES, AND TERM PREMIUMS IN THE DEFAULT-FREE DEBT MARKET

Under differential taxation of interest income and capital gains, heterogeneous personal tax rates may lead to the formation of tax clienteles according to coupon levels because investors have differing degrees of capital gains preference. This implies that marginal tax rates which are relevant for bond pricing may differ across coupon levels. This study derives a new equilibrium pricing model for default-free bonds under differential taxation of coupon income and capital gains, which explicitly considers coupon-induced tax clienteles. It is shown that all previous pricing equations are special cases of the model developed here.;This research also analyzes the tax effect on term premiums and the term structure of interest rates. An important finding is that forward rates are systematically downward biased estimates of expected future spot rates even in the absence of liquidity premiums. It is thus argued that term premiums are comprised of differential taxation compensations as well as liquidity premiums. Moreover, the magnitudes of the differential taxation effects on term premiums are monotonically increasing. Considering these tax effects, this study develops tax-adjusted expectations hypotheses of the term structure, which provide a better explanation regarding term premiums and the term structure. In particular, the anomaly of negative term premiums which has been documented in long maturity bonds is resolved.;Furthermore, this research shows that in a world with coupon-induced tax clientele effects, bond prices are a convex function of their coupon levels. In addition, the existence of coupon-induced tax clienteles appears to be consistent with market equilibrium. As well as presenting indirect evidence, this study provides direct evidence on the coupon-induced tax clientele effect by inspecting the equality of marginal tax rates estimated across different coupon levels employing the model derived herein. The results are also generally consistent with the traditional hypothesis regarding the direction of clienteles that implied tax rates are inversely related to coupon levels.