Working Paper: NBER ID: w1176
Authors: George M. Constantinides
Abstract: The tax law confers upon the investor a timing option--to realize capital losses and defer capital gains. With the tax rate on long term capital gains and losses being about half the short term rate, the tax law provides a second timing option--to realize capital losses short term and realize capital gains long term, if at all. Our theory and simulation with actual stock prices over the 1962-1977 period establish that the second timing option is extremely valuable: Taxable investors should realize their long term capital gains in high variance stocks and repurchase the same or similar stock, in order to reestablish the short-term status and realize potential future losses short term.Tax trading does not explain the positive abnormal returns of small firms. In the presence of transactions costs, tax trading predicts that the volumeof tax-loss selling increases from January to December and ceases inthe first few days of January. The trading volume seasonal maps into a stockprice seasonal only if tax-loss sellers are assumed irrational or ignorant of the price seasonality.
Keywords: capital gains; taxes; stock trading; variance; abnormal returns
JEL Codes: G12; H24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stock variance (G12) | optimal trading behavior (G40) |
| tax rates (H29) | trading decisions (G11) |
| trading decisions (G11) | stock prices (G12) |
| variance of stock (C46) | value of timing option to realize losses (C41) |
| tax-loss selling volume (G32) | small firm anomaly (L25) |
| stock prices exceed critical threshold (G10) | realize long-term gain (D25) |
| active trading policies (F13) | outperform buy-and-hold strategies (G11) |