Working Paper: NBER ID: w0762
Authors: Steven Kaplan
Abstract: United States tax law distinguishes between short-term and long-term capital gains. By taxing long-term gains at a lower rate the law creates an incentive for investors to postpone the realization of short-term gains. This study examines the lock-in effect induced by the differential tax treatment of long- and short-term gains. Analysis of data on corporate stock transactions from 1973 suggests that the lock-in effect is large and, thus, causes investors to alter their investment portfolios. The existence of such an effect is inefficient and results in a reduction in capital market efficiency. The inefficiency might be justified if there were convincing reasons which supported the existence of the holding period distinction. It is commonly argued, for instance, that eliminating the distinction would encourage short-term speculation at the expense of long-term commitment to capital. It is also claimed that this would result in a loss of revenue to the government. This study relies on IRS data and simulations using the NBER-TAXSIM file to examine the validity of these arguments. The results of this study suggest that the holding period distinction is not very effective in deterring speculation and does not increase government revenues; in fact, it may decrease them.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Differential tax treatment of capital gains (H24) | Lock-in effect (E43) |
| Lock-in effect (E43) | Investors discouraged from realizing short-term gains (G40) |
| Holding period transition from short-term to long-term (C41) | Realizations of capital gains increase (G19) |
| Holding period distinction (C41) | Suboptimal allocation of investment portfolios (G11) |
| Holding period distinction (C41) | Encourages speculation (D84) |
| Holding period distinction (C41) | Decrease in government revenues (H69) |
| Higher differential tax rate (H29) | Smaller realized gains (G19) |