Capital gain taxation is an important friction faced by investors when making asset allocation decisions. In this paper, we study the implications of a real world feature of most tax codes on portfolio choice with multiple stocks: that capital losses can only be used to offset current or future realized capital gains. We term this the limited use of losses (LUL). We show that this has strong implications for asset allocation and rebalancing of portfolios.
Specifically, an investor’s equity holdings are surprisingly lower and also exhibit strong time-variation across up and down equity markets compared to the case where the use of capital losses is unrestricted. This moves equity demands in a direction consistent with narrowing the equity premium puzzle. Interestingly, the model reproduces endogenously behavior that looks like time-varying risk aversion without having to rely on habit formation.
Studies of portfolio choice with capital gains taxation typically focus on two effects: a demand-side capitalization effect where a capital gain tax lowers the demand for equity and a supply-side lock-in effect where the capital gain tax lowers the effective supply of equity due to the unwillingness of investors with embedded capital gains to trade. We show that the proper modeling of capital gains taxation makes the optimal trading strategy much more sensitive to the capitalization effect relative to the lock-in effect. This impacts the dynamics of equity holdings. Specifically, an investor trading in a down market with capital losses or a flat market with small capital gains or losses should rebalance to significantly lower equity holdings than in an up market with large capital gains.
In contrast to our work, it is commonly assumed in the academic literature that the use of capital losses is unrestricted, termed the full use of losses (FUL). If capital losses are larger than capital gains in a period, the investor receives a tax rebate that cushions the downside of holding equity. While we would expect tax rebates to boost the demand for equity relative to the LUL case, what is surprising is the magnitude of the difference. For example, we document it is common for an FUL investor to hold even more equity than an untaxed investor when the portfolio contains no capital gains. Due to this increased demand for equity, an FUL-based capital gain tax system actually deepens the equity premium puzzle. Also, the tax rebate-induced mis-valuation of the capitalization effect overstates the value of tax loss selling. In particular, we commonly find that an untaxed investor would counterfactually be better off under an FUL-based capital gain tax compared to no capital gain tax.
Download
Portfolio Choice with Capital Gain Taxation and the Limited Use of Losses
