How much and how fast do investors respond to equity premium changes? Evidence from wealth taxation

Using administrative data on Norwegian investors’ portfolios, we document strong but slow portfolio allocation responses to a persistent wealth-tax-induced shock to the equity premium. Exploiting panel data that allow us to track portfolio allocations over time, we show that the short-run responses are weak and resemble those found in a growing survey-based literature. However, the longer-run responses are much larger and can be rationalized by a contained coefficient of relative risk aversion between 2 and 3. The finding that response size increases significantly over time suggests that portfolio adjustment frictions are pervasive. We further find that equity premium increases have large effects on stock market entry but that an equity premium decrease barely induces exits, which is consistent with the presence of both moderate entry costs, estimated at around $800, and considerably smaller per-period participation costs of around $90. Our finding of slow portfolio responses to equity premium shocks provides supportive evidence for the asset pricing literature that builds on adjustment frictions to explain a wide range of asset pricing puzzles. They also have implications for optimal capital taxation when tax rates can differ across assets.