We are interested in the effect of capital income taxes upon security prices when investors face locally segmented stock markets and a global bond market. Therefore, we analyze an equilibrium model of an economy with binomial uncertainty, an exogenous risk-free interest rate and a representative stand-in household. In this setting, the pricing effect for domestic securities is shown to be a function in three determinants: the covariance between pre-tax payoffs of securities and the aggregated market portfolio, the exogenous pre-tax interest rate and the effect of taxation (and redistribution) on the aggregate welfare of the stand-in household. We find that taxation of capital income is nondistorting if tax proceeds are immediately redistributed within the cohort of capital market participants. If, however, taxation represents a policy tool to transfer wealth from capital market participants to non-market participants, the level of the statutory tax rate is reflected in equilibrium security prices and taxation affects households portfolio decisions, which in turn may affect investment decision of firms.
equilibrium security prices capital income tax equity premium