35 4.3
k j
i m
r m
r
k j
k i
, ,
1 1
∀ −
= −
In equilibrium, it must be that
j i
r r
j i
, ∀
=
, and there are no tax distortions to portfolio choice.
4.2. Nonuniform income
taxation
In practice, tax rates on investment income commonly differ by type of asset, with rules differing by country. For example, relative tax rates on interest, dividends, and capital gains differ
by country; and the returns to certain assets are tax-exempt in some countries but not in others. Denote the tax rate on the return to asset i in country k by m
ik
. Then investors from that country are indifferent between holding any two assets i and j if and only if r
i
1-m
ik
=r
j
1-m
jk
. As emphasized by Slemrod 1988, this equality can hold simultaneously for investors from different countries for
only a very restrictive set of relative tax rates, yet actual tax structures are much more variable. Equilibrium portfolios are therefore distorted, given existing tax structures. In fact, without some
additional factors limiting portfolio choice such as restrictions on short sales there is no equilibrium. It is therefore important to consider the implications of nonuniform taxation of asset
income, and the factors that might reconcile them with observed portfolios. The preceding analysis of the effect of inflation takes foreign exchange gains and losses to
be taxed at the same rates as ordinary income. As emphasized by Gordon 1986, additional portfolio distortions are introduced if capital gains and losses resulting from changes in exchange
rates are not taxed at accrual – as is, for example, characteristic of equity investments that generate unrealized capital gains, or when tax systems fail to implement appropriate discount rules for long-
term bonds. In particular, bonds issued in countries with a high inflation rate might need to pay a
finding that the welfare costs of inflation in open economies have the potential greatly to exceed the costs of inflation in
36 high nominal interest rate to compensate for the capital loss that investors experience due to the
inflation. When the required addition to the nominal interest rate is taxed at a higher rate than applies to the associated capital loss due to inflation, the size of the increase in the interest rate
needed to compensate for inflation will be higher the higher the tax rate of the investor. As a result, these bonds will be purchased primarily by investors facing low tax rates. If exchange rates were
riskless, then a costless form of tax arbitrage becomes feasible, with investors in high tax brackets borrowing in countries with a high inflation rate and investing in bonds from countries with a low
inflation rate, and conversely for investors in low tax brackets. When different types of assets face different tax rates, their pretax rates of return will adjust
in equilibrium to compensate for the differences in tax treatment, so that heavily taxed assets offer the highest pretax rates of return. This observation has interesting implications for tax policy. For
a country raising capital from abroad, the pretax rate of return it has to pay to foreign investors will be higher if the financial asset used will face higher domestic tax rates in the investors’ home
countries. By this argument, bond finance should be more expensive than equity finance, at least after controlling for risk. However, when interest but not dividend payments are deductible under
the corporate tax, firms may prefer debt to equity finance – due to the deductibility of interest payments, debt finance can be cheaper to the firm even when it is more expensive for the country
as a whole. The government absorbs the extra costs through the fall in tax revenue, and so has a strong incentive to reduce or eliminate the tax advantage to debt finance.
48
Similarly, when domestic investors have a tax incentive to buy equity or other more lightly taxed assets, the pretax
return they earn is reduced, which again would be reflected in a fall in government tax revenue.
closed economies.
48
For further discussion, see Gordon 1986.
37 This pressure towards equal tax treatment of different type of assets is an example of the gains from
productive efficiency described in Diamond and Mirrlees 1971.
4.3. Home bias
