Taxes and Stock Returns: Time Series and Cross-Sectional Predictability at the Turn of the Year

Abstract

We provide a novel way to study the hypothesis that taxation distorts stock prices. In our analytical framework, a rational investor trades off realizing tax losses (gains) this year instead of next year in the presence of underpricing (overpricing). As a consequence, such optimal tax selling can generate stock return momentum at the end of the year and a corresponding reversal at the beginning of the subsequent year whose magnitude are not only a function of a stock's tax basis but also a function of interest and capital-gains tax rates. Our tax-selling variable describes predictable patterns in the cross section of average returns at the turn of the year. These patterns continue to exist after controlling for characteristics linked to return predictability. Consistent with our story, we find that these patterns are more precisely measured in stocks with below-median institutional ownership.