Capital Gains Taxes and Risk with a Fixed Supply of Risky Assets

Abstract

Economic theory has long argued that when risk-averse investors are price-takers, a tax on risky returns (with full tax benefit for losses) will cause investments in risky assets to increase because the tax reduces after-tax risk. We extend this result to a setting with a fixed supply of risky assets, so that the increased demand due to lower after-tax risk leads to an increase in price and a decrease in pre-tax returns. In this setting the tax-induced increase in demand for risky assets is mitigated by the lower pre-tax returns, and the increase is much smaller than predicted by previous models. Our results have important implications for understanding how taxes affect investor behavior and for studies in accounting that examine the effect of taxes on investments in risky assets.