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Optimal Stock Trading with Personal Taxes: Implications for Prices and the Abnormal January Returns

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  • 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1176.

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Date of creation: Aug 1983
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Publication status: published as Constantinides, George M. "Optimal Stock Trading with Personal Taxes: Implications for Prices and the Abnormal January Returns." Journal of Financial Economics, Vol. 13, No. 1, (1984), pp. 65-89.
Handle: RePEc:nbr:nberwo:1176

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  1. Constantinides, George M & Scholes, Myron S, 1980. " Optimal Liquidation of Assets in the Presence of Personal Taxes: Implications for Asset Pricing," Journal of Finance, American Finance Association, American Finance Association, vol. 35(2), pages 439-49, May.
  2. Rozeff, Michael S. & Kinney, William Jr., 1976. "Capital market seasonality: The case of stock returns," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(4), pages 379-402, October.
  3. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, Econometric Society, vol. 41(5), pages 867-87, September.
  4. Mustafa N. Gultekin & Bulent N. Gultekin, . "Stock Market Seasonality and End of the Tax Year Effect," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 10-82, Wharton School Rodney L. White Center for Financial Research.
  5. Sidney B. Wachtel, 1942. "Certain Observations on Seasonal Movements in Stock Prices," The Journal of Business, University of Chicago Press, vol. 15, pages 184.
  6. Stoll, Hans R. & Whaley, Robert E., 1983. "Transaction costs and the small firm effect," Journal of Financial Economics, Elsevier, Elsevier, vol. 12(1), pages 57-79, June.
  7. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  8. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, Elsevier, vol. 7(3), pages 229-263, September.
  9. Branch, Ben, 1977. "A Tax Loss Trading Rule," The Journal of Business, University of Chicago Press, vol. 50(2), pages 198-207, April.
  10. Keim, Donald B., 1983. "Size-related anomalies and stock return seasonality : Further empirical evidence," Journal of Financial Economics, Elsevier, Elsevier, vol. 12(1), pages 13-32, June.
  11. Reinganum, Marc R., 1981. "Misspecification of capital asset pricing : Empirical anomalies based on earnings' yields and market values," Journal of Financial Economics, Elsevier, Elsevier, vol. 9(1), pages 19-46, March.
  12. Dyl, Edward A, 1977. "Capital Gains Taxation and Year-End Stock Market Behavior," Journal of Finance, American Finance Association, American Finance Association, vol. 32(1), pages 165-75, March.
  13. Constantinides, George M, 1983. "Capital Market Equilibrium with Personal Tax," Econometrica, Econometric Society, Econometric Society, vol. 51(3), pages 611-36, May.
  14. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  15. Brown, Philip & Kleidon, Allan W. & Marsh, Terry A., 1983. "New evidence on the nature of size-related anomalies in stock prices," Journal of Financial Economics, Elsevier, Elsevier, vol. 12(1), pages 33-56, June.
  16. Banz, Rolf W., 1981. "The relationship between return and market value of common stocks," Journal of Financial Economics, Elsevier, Elsevier, vol. 9(1), pages 3-18, March.
  17. Brown, Philip & Keim, Donald B. & Kleidon, Allan W. & Marsh, Terry A., 1983. "Stock return seasonalities and the tax-loss selling hypothesis : Analysis of the arguments and Australian evidence," Journal of Financial Economics, Elsevier, Elsevier, vol. 12(1), pages 105-127, June.
  18. Chen, Nai-fu, 1983. " Some Empirical Tests of the Theory of Arbitrage Pricing," Journal of Finance, American Finance Association, American Finance Association, vol. 38(5), pages 1393-1414, December.
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