Optimal Consumption and Investment with Capital Gains Taxes

Dammon, Robert M.; Zhang, Harold H.; Spatt, Chester S.

doi:10.2139/ssrn.282756

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Optimal Consumption and Investment with Capital Gains Taxes

Review of Financial Studies, Vol. 14, No. 3, pp. 583-616, Fall 2001

34 Pages Posted: 30 Sep 2001

See all articles by Robert M. Dammon

Harold H. Zhang

University of Texas at Dallas - Naveen Jindal School of Management; China Academy of Financial Research (CAFR)

Chester S. Spatt

Carnegie Mellon University - David A. Tepper School of Business

Abstract

This article characterizes optimal dynamic consumption and portfolio decisions in the presence of capital gains taxes and short-sale restrictions. The optimal decisions are a function of the investor's age, initial portfolio holdings, and tax basis. Our results capture the trade-off between the diversification benefits and tax costs of trading over an investor's lifetime. The incentive to rediversify the portfolio is inversely related to the size of the embedded gain and investor's age. Contrary to standard financial advice, the optimal equity holding increases well into an investor's lifetime in our model due to the forgiveness of capital gains taxes at death.

Keywords: Capital gains taxes; Optimal consumption and investment policies; Diversification and tax costs; Reset provision

JEL Classification: G11, H20

Suggested Citation: Suggested Citation

Dammon, Robert M. and Zhang, Harold Huibing and Spatt, Chester S., Optimal Consumption and Investment with Capital Gains Taxes. Review of Financial Studies, Vol. 14, No. 3, pp. 583-616, Fall 2001, Available at SSRN: https://ssrn.com/abstract=282756 or http://dx.doi.org/10.2139/ssrn.282756