Optimal Consumption and Investment with Asymmetric Long-Term/Short-Term Capital Gains Taxes

52 Pages Posted: 19 Mar 2012

See all articles by Min Dai

Min Dai

National University of Singapore (NUS) - Department of Mathematics

Hong Liu

Washington University in St. Louis - Olin Business School; Fudan University - China Institute of Economics and Finance

Yifei Zhong

University of Oxford - Mathematical Institute; University of Oxford - Mathematical Institute

Date Written: February 9, 2012

Abstract

We propose an optimal consumption and investment model with asymmetric long-term/short-term tax rates. We also consider both the case where an investor can get full tax rebate for capital losses and the case where the investor can only carry over capital losses. The full rebate case is a better model for low income investors while the carry over case is more suited for wealthy investors. The optimal trading strategy is characterized by a time-varying no-transaction region outside which it is optimal to realize capital gain or loss to achieve the optimal fraction of after-tax wealth invested in stock. We show that the optimal consumption and investment policy is qualitatively different from what is found in the standard literature and the optimal policy for low income investors is qualitatively different from that for wealthy investors. More specifically, for low income investors, (1) it can be optimal to defer capital loss realization beyond one year even in the absence of transaction costs and wash sale restriction; (2) it can be optimal to defer long-term capital gains even when the rebate rate for short-term losses is high; (3) raising the short-term tax rate can significantly increase both consumption and stock investment; (4) higher tax rates (such those for wealthy investors) can make them significantly better off.

Keywords: Capital Gains Tax Law, Portfolio Selection, Consumption

JEL Classification: G11, H24, K34, D91

Suggested Citation

Dai, Min and Liu, Hong and Zhong, Yifei, Optimal Consumption and Investment with Asymmetric Long-Term/Short-Term Capital Gains Taxes (February 9, 2012). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=2024430 or http://dx.doi.org/10.2139/ssrn.2024430

Min Dai

National University of Singapore (NUS) - Department of Mathematics ( email )

Singapore

Hong Liu (Contact Author)

Washington University in St. Louis - Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-5883 (Phone)

Fudan University - China Institute of Economics and Finance ( email )

China

Yifei Zhong

University of Oxford - Mathematical Institute ( email )

Mathematical Institute
24-29 St Giles
Oxford, Oxfordshire OX1 3LB
United Kingdom

University of Oxford - Mathematical Institute ( email )

24-29 St Giles'
Oxford, OX1 3LB
United Kingdom

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