Does Corporate Tax Affect Equity Price?

Abstract

Background: This study aims to examine the theoretical implications of corporate income tax for asset pricing in a two-tree aggregate-endowment economy. Methods: We employ a mechanism through which corporate income tax can increase or decrease the “portfolio risk” associated with the rebalancing motive when clearing the market. We view an asset as a portfolio of stocks and bonds, and the portfolio weights are related to financial leverage. Results: Corporate tax can decrease the after-tax consumption from dividends (increase leverage), but can also increase the tax shield and add to dividends (decrease leverage). Changes in dividends are responsible for the correlation between expected dividend growth and consumption growth and, thus, affect the stock price/return. Conclusion: Overall, the model introduces the role played by tax-induced portfolio risk in asset characteristics.