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Portfolio Selection with Capital Gains Tax, Recursive Utility, and Regime Switching

Author

Listed:
  • Jiatu Cai

    (Laboratoire de Probabilités et Modèles Aléatoires, Université Paris-Diderot (Paris 7), 75013 Paris, France)

  • Xinfu Chen

    (Department of Mathematics, University of Pittsburgh, Pittsburgh, Pennsylvania 15260)

  • Min Dai

    (Department of Mathematics, Risk Management Institute, and Suzhou Research Institute, National University of Singapore, Singapore 119077)

Abstract

Capital gains taxation has important implications for investors’ portfolio choice decisions. To explore these implications, we develop a continuous time investment and consumption model with capital gains tax, Epstein–Zin recursive utility, and regime switching. We find that various factors, such as tax rate, risk aversion, interest rate, stock return, and volatility, jointly affect optimal portfolio allocation, whereas intertemporal substitution does not. In a regime switching market, investors may trade or stop trading purely because of a change in regime, and there is a distinct cross-regime effect on optimal portfolio allocation. In particular, investors tend to raise stock investment in a bear regime so as to reduce potential tax payments upon regime switching. Given reasonable parameter values, regime switching has a greater impact on optimal portfolio allocation in a bear regime than in a bull regime.

Suggested Citation

  • Jiatu Cai & Xinfu Chen & Min Dai, 2018. "Portfolio Selection with Capital Gains Tax, Recursive Utility, and Regime Switching," Management Science, INFORMS, vol. 64(5), pages 2308-2324, May.
    • Handle: RePEc:inm:ormnsc:v:64:y:2018:i:5:p:2308-2324
    DOI: mnsc.2016.2650
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    References listed on IDEAS

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