Inflation, Taxation, and Capital Gains Indexation: Portfolio Choice and Welfare Implications
66 Pages Posted: 18 Nov 2019 Last revised: 11 Dec 2019
Date Written: November 8, 2019
We examine an optimal investment and consumption problem in the presence of inflation risk and capital gains tax. We show that the concern about inflation can significantly strengthen an investor's incentive to defer gains realizations, leading to a first-order increase in the value of tax-timing. Further, capital gains taxation can make low income investors unconditionally better off if stock dividends are accounted for and this effect is stronger when inflation risk is considered. Moreover, indexing cost basis by inflation could encourage low (high) income investors to realize (defer) more gains. Low income investors may benefit more from capital gains indexation, even though the tax rates are lower for them. Given the average inflation rate in the United States, indexing the cost basis could be more favorable than lowering the long-term capital gains tax rates to their current levels.
Keywords: Portfolio Choice, Inflation risk, Capital gains tax, Capital gains indexation
JEL Classification: G11, H24, K34
Suggested Citation: Suggested Citation