Optimal Consumption and Investment with Capital Gains Taxes

34 Pages Posted: 30 Sep 2001

See all articles by Robert M. Dammon

Robert M. Dammon

Carnegie Mellon University

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

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

Robert M. Dammon

Carnegie Mellon University ( email )

GSIA
Pittsburgh, PA 15213
United States
412-268-3696 (Phone)

Harold Huibing Zhang (Contact Author)

University of Texas at Dallas - Naveen Jindal School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

Chester S. Spatt

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
412-268-8834 (Phone)
412-268-6689 (Fax)

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