Arbitrage and Martingales with Taxation

This paper extends the martingale analysis of no arbitrage pricing to worlds with taxation. The absence of arbitrage is shown to imply the existence of different shadow prices for income streams that are subject to differing tax treatments. For example, no arbitrage im- plies the existence of different martingale measures for capital gains and for ordinary income when they are differentially taxed and for items such as depreciation expenses that influence only after-tax cash flows. The analysis is applied to several topics in finance includ- ing the debt/equity decision, tax options, and the taxation of divi- dends and pensions.