Do Tax-Exempt Investors Mitigate the Dividend Tax Penalty?

We investigate the effect of shareholder taxes on expected stock returns using a model that characterizes both the optimal portfolios of taxable and tax-exempt investors and the expected rates of return on risky stocks. When all income is taxed at the same effective rate, each investor's ownership in each risky stock depends only on that investor's relative tolerance for risk. Taxes induce taxable investors to hold more of the tax-favored stock, but risk-sharing considerations induce each investor to hold some stock unless the riskiness of the stock is sufficiently low. There is no quot;marginal investorquot; in this case. Each stock's expected return reflects a quot;dividend tax penalty,quot; but the dividend tax penalty is not mitigated by the fraction of shares held by the tax-exempt investors. Although the presence of the tax-exempt investors in the market does mitigate the dividend penalty for the market as a whole, this effect is identical for all firms held by both taxable and tax-exempt investors and does not vary with the fraction of shares held by the tax-exempt investors