Effective operation of the capital market depends on a proper environment provided for by good and sound macroeconomic policies of which fiscal policy is paramount. Poor design of the tax system and over-taxation of financial assets may constrain the process of capital market development and effective functioning of the financial sector in general. This paper examines the effect of tax policy on the profitability of financial assets and its implication on the development of capital market in Tanzania. Using data for the period May 1998 - December 2002, pre-tax and after-tax rates of return and effective tax rates on five financial assets are calculated as a means of defining the impact of taxation on each asset. It is observed that although taxation significantly reduces returns on all the five assets, listed equities arc the least taxed assets of all financial assets due to tax incentives they enjoy. The findings suggest that Tanzania's tax policy is not an obstacle to investors' participation in the capital market. Light taxation of financial assets leads to their insignificant contribution to government revenue, but it acts as an incentive that enhances the demand for market instruments and lays a good foundation for development of the capital market. It is noted, however, that existing capital market incentives are geared to stimulating demand than supply of capital market instruments, as they do not encourage companies from the private sector to source funds through the capital market. The supply side of the stock market can be further stimulated through such tax incentives as reduction of corporate taxation for listed companies and provision for companies to carry forward capital losses arising from investments in the capital market against total taxable income. The paper also emphasizes the need for increased effort to enhance awareness to ordinary Tanzanians on the workings and benefits of the stock market.