Optimal Tax-Timing with Transaction Costs

Abstract

We develop a dynamic portfolio model incorporating capital gains tax (CGT), transaction costs, and year-end taxation. We find that even tiny transaction costs can lead to significant deferral of large losses and transaction costs affect loss deferrals much more than gain deferrals. Our model can thus help explain the puzzle that even when investors face  equal long-term/short-term CGT rates, they may still defer realizing large capital losses for an extended period of time, displaying the disposition effect. In addition, we find misestimating transaction costs is costly. We also provide several unique, empirically testable predictions and shed light on recently proposed tax policy changes.

Keywords: portfolio choice, capital gains tax, transaction costs, delayed tax

JEL Classification: G11, H24, K34, D91