Taxation, investment and asset pricing

This paper studies the impact of dividend and corporate income 'taxes on investment and asset returns in a stochastic general equilibrium model. Under the "new" view of dividend taxation (e.g. Poterba and Summers, 1985), proportional dividend taxes do not distort investment decisions, and thus have no impact on asset returns. By contrast, we find that corporate income taxes introduce additional tax-related risk factors into the economy by distorting investment decisions. We uncover a mechanism through which corporate taxes amplify the responses of consumption and investment to technology shocks, and consequently lead to a lower risk-free interest rate and a higher equity premium. This amplification mechanism is the strongest when there exists a strong preference for consumption smoothing and high costs of adjusting the capital stock. (C) 2010 Elsevier Inc. All rights reserved.