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

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.