High-water mark investment taxation ($dw=rwdt+\theta [\sigma dW+(\mu -r)dt]-cdt-\tau d\bar{w}$)

A high-water mark investment tax charges increments of historical maximum wealth ${\bar{w}}_t=\max ({\bar{w}}_0,{\sup }_{s\le t}{w}_s)$ rather than every positive instantaneous return. For the convention charging $\tau d\bar{w}$, the high-water mark tax boundary condition is $V_{\bar{w}}=\tau V_w$ when the optimal policy raises the maximum. At sufficiently high tax, a wealth-cap investment boundary can make further maximum increases suboptimal.

A wealth-cap investment boundary prevents wealth from exceeding a fixed historical maximum. In the wealth-variable Legendre dual for wealth normalized by that maximum, $J^{\prime }(z_{\ast })=-1$ and vanishing optimal portfolio volatility gives $J^{\prime \prime }(z_{\ast })=0$. For power utility and a high-water tax, the smooth tax-paying solution has boundary dual curvature $(1-\alpha \tau )/(R{z}_{\ast })$, so it cannot be admissible when $\alpha \tau >1$.

At an active maximum-raising boundary in high-water mark investment taxation, the finite-variation part of the Itô formula is $(V_{\bar{w}}-\tau V_w)d\bar{w}$, so smooth optimality sets this coefficient to zero. If the maximizing policy avoids increasing the maximum, the corresponding inequality $V_{\bar{w}}-\tau V_w\le 0$ is compatible with a wealth-cap investment boundary instead.