Investors face both dividend taxes and capital gains taxes. Dividend taxes are incurred when corporations make cash distributions to shareholders, and capital gains taxes are incurred when securities are sold. From recent data, Sialm (2006) estimates that 55% of U. S. equity is held in a taxable account. Even though the majority of equity is subject to taxation, the finance literature has not produced any after-tax stock indices. This paper considers the direct impact of both types of taxation on various portfolio strategies. Our calculations assume realistic optimizing tax-realization strategies, with the highest-basis shares of given companies sold before lower-basis shares. Our results provide new evidence on the impact of investment taxation on investment performance. Contrary to the view that dividend yield is a sufficient statistic for measuring tax burden, we find that capital gains tax-timing options induce differences in tax burdens that are related to portfolio style and composition method.
The optimal tax-trading strategy is to sell stocks that have lost value relative to their tax basis and hold stocks that have gained value relative to their basis. Because of this, different portfolio strategies, which differ in the degree to which gains and losses are deferred and harvested, will have specific style and composition-related tax burdens. For example, portfolio strategies that involve maintaining equal position weights, small market capitalization stocks, and value stocks induce capital gains realizations in positions that have done well, and defer realization in stocks that have done poorly. This creates a high capital gains tax burden for taxable investors who follow these portfolio strategies.
On the other hand, portfolios where holdings are value weighted, portfolios of large market capitalization stocks, and portfolios of growth stocks correspond more closely to the optimal tax-trading strategy. Thus, the differences that we document in the after-tax returns to different strategies come not only from differences in the patterns of pre-tax returns, but from differences in the pattern of capital gains realizations induced by the need to maintain these particular portfolio strategies.
We calculate the after-tax returns to a set of benchmark portfolios that includes a value weighted index, an equally-weighted index, portfolios of small and large firms, portfolios of value and growth firms, and portfolios sorted by dividend yield. Taxation has a large impact on portfolio returns and wealth accumulation. Our analysis shows that an investor, taxed over the 1926-2002 period at the rates prevailing at the 95th percentile of income, and holding an equal weighted portfolio of NYSE stocks, accumulates a portfolio worth only 26.9% as much as a tax exempt investor holding the same portfolio over the same period. Given the tax rates prevailing at the 99.5th percentile of the income distribution, the estimated terminal portfolio value is only 14.1% of as much as a tax-exempt investor.
