Taxation of Capital Gains with Deferred Realization

Abstract

This paper challenges accepted methods of calculating the effect of deferred realization on the effective rate of capital gains tax paid by common shareholders and their overall tax burden. Those methods are shown to implicitly assume the special case of gains accrued in lump sum, even under the common scenario of gains accrued gradually over time. A widely-accepted method is also shown to overstate the effect of deferral by implicitly using the internal rate of return as a discount rate. The valuation-based method proposed here is especially useful for growth stocks where gains are accrued gradually and realized in lump sum. The same method is used to calculate the firm's cost of retained earnings under a finite deferral period. Depending on the tax and interest rates and the extent of deferment, the accuracy gained by using the proposed method can better inform shareholders, their firm's investment and distribution policies, and government tax policy.

See reply: National Tax Journal, Vol. 44, No. 1, March 1991.

Keywords: growth stocks, shareholder effective capital gains tax, capital gains tax deferment, cost of capital, share valuation, payout policy

JEL Classification: G35, H24, H25