This paper received the Runner-Up Award for the Barclays Global Investors/Michael Brennan Prize for Best Paper published in the Review of Financial Studies, 2001 (Volume 14).
Taxes play an important role when individuals make decisions about their consumption and saving plans. The taxation of investment returns alters the benefits of saving for future consumption, and consequently affects the tradeoff between saving and current consumption. Furthermore, the ability of investors to defer the taxation of capital gains alters the relative valuation of equities and bonds and may in turn affect the optimal portfolio allocations of investors. The deferral feature of capital gains taxes also affects the tradeoffs investors face regarding taxes and diversification. Investors would ideally like to maintain an optimally diversified portfolio over time, but the desire to rebalance may conflict with the desire to delay the taxation of capital gains.
Professors Spatt, Dammon, and Zhang examine the optimal dynamic consumption, investment, and liquidation decisions of a risk-averse investor in the presence of capital gains taxes and short-sale restrictions. The investor allocates his wealth between a riskless, one-period bond and a risky stock. The price of the risky stock follows a binomial process. The riskless bond pays a constant interest rate. The researchers assume that the investor’s tax basis in the stock is calculated as the weighted average purchase price. Although the tax-timing option is more valuable if the investor identifies each purchase with its own tax basis, the assumption that the investor uses the weighted average purchase price as the tax basis for all shares held keeps the dimensionality of the state space constant over time. However, even with these assumptions the researchers cannot obtain a closed-form solution to the dynamic programming problem and therefore use numerical techniques for their analysis.
The numerical results indicate that the optimal consumption-wealth ratio is lower with taxes and increasing in the basis-price ratio. The incentive to sell assets with embedded capital gains in order to diversify is inversely related to the size of the gain and the age of the investor. The investor’s age plays an important role in the optimal realization decision because, under the current U.S. tax code, all unrealized capital gains and losses are treated as tax-exempt at the time of death. This favorable tax treatment afforded capital gains at death increases the value of the option to realize losses and defer gains for elderly investors. Consequently, in their model, the optimal holding of equity increases well into an investor’s life.
The researchers illuminate the importance of the difference between income taxes and capital gains taxes on portfolio composition. The proportion of the investor’s portfolio allocated to equities is higher in the presence of differential income and capital gains tax rates (and rules). This is due to the fact that interest income on bonds is fully taxable when received, whereas capital gains (and losses) are taxed only when the investor sells the asset and escape taxation altogether at the time of the investor’s death. Thus the lower the tax basis, the lower the consumption-wealth ratio. For elderly investors, the consumption decision is driven primarily by the investor’s bequest motive and the desire to defer the realization of capital gains to benefit from the reset provision at death. For young investors, the bequest motive and reset provision at death are relatively less important because of their lower mortality rates.
Click here for a summary article on this study, which appeared in the Winter 2002 Issue of Quarterly, a TIAA-CREF Institute publication.
