MARKET EQUILIBRIUM WITH CAPITAL LOSS DEDUCTION OPTIONS

This research builds on a widely-cited study to prove that the permissible tax loss deduction subsidizes investments in volatile securities by materially lowering the required expected return on more volatile assets. The implications of the theory are robust to the existence of transaction costs, dividends, forced liquidations, and a ceiling on capital loss deductions in some countries. It is further shown that special tax treatment at death significantly increases the value of the tax deduction option. The theoretical model is explained to be consistent with empirical findings reported in the literature and to actually help explain some asset pricing anomalies.