Tax-exempt Investors and the Asset Allocation Puzzle

Investors frequently hold equity in tax-exempt savings vehicles such as pension plans, despite the prediction of the standard model that they hold only bonds. We provide a new explanation for this empirical puzzle based on differences between pensions and taxable assets in the tax treatment of capital losses. We show how limits on refundability of losses on taxable equities leads to diversity of investors’ preferences for corporate leverage on the basis of tax rates. In the simplest equilibrium of the model, taxexempt savers hold risky, highly leveraged equities, while low-bracket taxable savers hold bonds and high-bracket taxpayers hold relatively safe, unleveraged equities. We discuss the implications of tax-exempts for risk taking and agency costs within the firm. JEL Classification: H25 Jack Mintz University of Toronto Joseph L. Rotman School of Management 105 St. George St. Toronto, ON M5S 3E6 Canada email: [email protected] Michael Smart University of Toronto Department of Economics and Institute for Policy Analysis 140 St. George St. Toronto, ON M5S 3G6 Canada email: [email protected]