Dynamic Arbitrage Pricing with Progressive Taxation

This paper investigates arbitrage-free valuation of financial assets in multi-period markets where asset returns are progressively taxed. It is demonstrated that the arbitrage-free pricing intervals are determined by the highest and lowest marginal tax rates, independently of the local behavior of tax schedules. The result of the paper is built on the notion of arbitrage discussed in Won(2007) in a general framework of return-related market frictions. The general notion of arbitrage is shown to be equivalent to a stronger form of tax arbitrage of Dammon and Green(1987) when it is specialized to the case with progressive taxation. The consequence of the paper is also an extension of the two-period tax arbitrage of Dammon and Green(1987) to multi-period markets.