Tax-induced clientele effects in the market for British government securities: Placing bounds on security values in an incomplete market

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Abstract

This paper develops a new methods for measuring tax effects in bond markets and presents empirical results for British Government Securities. The basic idea is to construct a least cost portfolio which, for investors in a given tax bracket, dominates a given bond. A portfolio is said to dominate a bond if it provides cash flows which are at least as great in every period, and has a lower price. In effect our method calculates an upper bound on the value of a bond to investors in a given tax bracket. The results demonstrate (i) the existence of clientele effects and (ii) the absence of an ‘effective tax rate’.

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    This paper is based on the author's Ph.D. thesis. Thanks — with the usual caveat — for helpful comments on this and previous versions are due to many individuals but particularly to Richard Brealey, Michael Brennan, the late Paul Cootner, George Feiger, Stewart Hodges, Alan Kraus, Robert Litzenberger and Merton Miller. The comments of the referee, John Long, were especially helpful. Ted Day and Wayne Ferson provided excellent research assistance, and Ailsa Land of L.S.E. very kindly allowed me to use her mathematical programming package. Financial support from the Stanford Program in Finance and the London Business School is very gratefully acknowledged.

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