Tax-induced Trading Research Articles

Stock volatility and trading

Both, rational and behavioral models predict that stock and market volatility affect trading by investors. Tax-induced trading hypothesis predicts that investors increase realization of capital losses short term and capital gains only long term as volatility increases. Behavioral models predict that disposition biases of holding on to losers and disposing of winners intensifies with volatility. We document that market and stock volatility influence stock trading. Evidence on trading in response to rise in market volatility supports tax-loss harvesting hypothesis – abnormal trading of losers increases and winners decreases. However, evidence on trading patterns conditional on individual stock volatility is in support of both tax-loss-harvesting and behavioral models: trading in both losing stocks (tax-loss-harvesting hypothesis) and winning stocks (disposition effect hypothesis) increases with rise in stock volatility.

Asymmetric tax-induced trading: The effect of capital gains tax changes

We examine the effect of confirmed and tentative changes in long-term capital gains tax rates on direction and magnitude of tax-induced trading. Results show that investors have an asymmetric response to tax rate changes. For all tax events, investors adjust trading in losers more than in winners. Between tax events, investors respond more to a tax rate decrease than to a tax rate increase for both losing and winning stocks. Tax-induced trading activity shows that investors do not differentiate between unconfirmed and confirmed tax rate increases. Uncertainty about an impending tax rate change alters investors’ trading behavior and may affect government tax collections.

The Moderating Impact of Individual Ownership on The Relationship between Dividend Yield and Ex-dividend Day Excess Return

This study investigates the moderating impact of individual ownership on the relationship between dividend yield and ex-dividend excess return. Our sample includes US listed companies for years 2002 to 2010. A cross-sectional regression analysis is done to reveal the moderating impact of individual ownership. Our findings show that there is a positive relationship between dividend yield and ex-dividend day excess return in line with tax clientele theory. We also found that the relationship between dividend yield and the ex-dividend day excess return is positively moderated by individual ownership. These findings reveal that the positive relationship between dividend yield and ex-dividend day excess return stems from individual investors’ dividend tax misgiving in line with tax clientele theory. Moreover, we found a negative relationship between corporate size and ex-dividend day excess return that supports the short selling theory. We conclude that tax-induced dynamic trading theory is the premier justification of ex-dividend day pricing as the mixture of both tax clientele and short selling theories.

Buyers versus Sellers: Who Initiates Trades and When?

We study the relation between order imbalance and past returns and firm characteristics and test a number of hypothesis including the disposition effect, momentum and contrarian trading, taxloss selling and flight-to-quality hypothesis. These hypotheses make predictions about investors’ buy or sell decisions, but previous studies that test these hypotheses use turnover data that combine both buyer and seller-initiated trades. We find that investors behave as contrarians over short horizons and as momentum traders over longer horizons. We find strong support for seasonal tax induced trading but little evidence of flight-to-quality.

Ex-Dividend Day Price and Volume: The Case of 2003 Dividend Tax Cut

We examine the impact of the 2003 dividend tax cut, which removes the differential taxation between dividends and capital gains for individual investors, on the ex-dividend day price and trading volume. We find the ex-dividend day price and volume are affected by taxes, risk, and transaction costs. The ex-dividend day price drop ratio (excess return) increases (decreases) and dividend clienteles weaken after the tax cut. Ex-dividend day abnormal volume among high dividend yield stocks decreases after the tax cut consistent with a diminished motivation for tax-induced trading. Our results suggest that individual investors have a measurable effect on the ex-dividend day price and trading volume.

Tax Heterogeneity and Trading Volume Around the Ex-Dividend Day: Estonian Evidence

This paper examines the trading pattern around the ex-dividend day in the Estonian stock market between 2000 and 2006. An analysis of the Estonian income tax law confirmed that despite its simplicity there exists differential treatment of capital gains and dividends as well as tax heterogeneity among investors. An empirical analysis of the trading data showed a statistically significant abnormal trading volume around the ex-dividend day. By putting these two aspects together and investigating short-term changes in ownership structure around the ex-dividend day it can be concluded that in the Estonian stock market investors use dynamic tax-induced trading strategies around the ex-dividend day. The occurrence of the learning effect and avoidance of transaction costs were also revealed by an analysis of these transactions.

Taxes and Foreign Investors' Trading Behavior Around Ex-Dividend Days

The primary purpose of this paper is to examine the tax effect on foreign investors' trading behavior around ex-dividend days on the Taiwan Stock Exchange. We find that despite the tax disadvantage of participating in taxable dividend distributions, foreign investors still buy more before the ex-date and sell more on the ex-date or afterwards. Their trading behavior around the ex-date fully contradicts with the prediction of the tax hypothesis. As the distribution rate is higher, their order imbalances before the ex-date also increase, but decrease afterwards. The evidence implies that foreign investors are engaged in short-term arbitrage trading around ex-dividend days rather than tax-induced trading.

Tax-Induced Trading and the Identity of the Marginal Investor: Evidence from Sweden

Changes in the Swedish tax code during the 1990s were structured in a way that offers an opportunity to test whether ex-dividend prices were determined by the taxation of domestic individual investors. The results presented in this paper indicate that ex-dividend prices were not influenced by the relatively large tax changes for domestic individual investors. In addition, there was no evidence that the taxation of domestic individual investors influenced ex-dividend prices for any specific dividend yield group.

Tax-Induced Trading around the Taxpayer Relief Act of 1997

ABSTRACT: We examine investor trading around the passage of the Taxpayer Relief Act of 1997 (TRA97), which reduced the capital gains tax rate from 28 percent to 20 percent. We provide evidence that individual investors increase their demand for equity shares on the announcement day of TRA97, consistent with the capitalization of capital gains taxes. On the effective day of TRA97, we find that individual investors increase the supply of equity shares with accrued gains, consistent with the lock-in effect of capital gains taxes. Regression results suggest that the demand-side effect associated with tax capitalization is a more powerful effect on abnormal trading than the supply-side effect associated with lock-in for the median stock trading around TRA97. Overall, our results suggest that capital gains taxes influence both the demand and supply for equity by tax-sensitive investors and that the effect on demand is more pronounced than the effect on supply.

Tax management strategies with multiple risky assets

We study the consumption-portfolio problem in a setting with capital gain taxes and multiple risky stocks to understand how short selling influences portfolio choice with a shorting-the-box restriction. Our analysis uncovers a novel trading flexibility strategy whereby, to minimize future tax-induced trading costs, the investor optimally shorts one of the stocks (or equivalently, buys put options) even when no stock has an embedded gain. Alternatively, an imperfect form of shorting the box can reduce aggregate equity exposure ex post. Given these two short selling strategies, it is common for an unconstrained investor to short some equity while a constrained investor holds a positive investment in all stocks. With no shorting, the benefit of trading separately in multiple stocks is not economically significant.

Tax Management Strategies with Multiple Risky Assets

We study the consumption-portfolio problem of a capital gain taxed investor who has access to multiple risky stocks. Primary to our analysis is to understand how costly short selling influences portfolio choice with a shorting the box restriction. Our analysis uncovers two different strategies where it is optimal to short sell. The first, identified as a trading flexibility strategy which is new in our analysis, is an ex ante way of minimizing future tax-induced trading costs. With this strategy, the investor shorts one of the stocks even when no stock has an embedded gain. The second shorting strategy is an imperfect form of shorting the box used to ex post reduce aggregate equity exposure. Given these two short selling strategies, it is common for an unconstrained investor to short some equity while a constrained investor holds a positive investment in all stocks. A similar trading flexibility strategy is implicitly present if the investor can not short but is allowed to buy put options. Somewhat surprisingly, the benefit of trading separately in the two stocks for a short sale constrained investor is not economically significant; while, on the other hand, the welfare benefit is significant for an investor who can short at a low cost or who can trade in derivatives.

Do capital gain tax rate increases affect individual investors’ trading decisions?

This paper examines individual investors’ short- and long-term trading reactions to the 1986 Tax Reform Act's (TRA 86) capital gain tax rate increase. Consistent with a tax-induced trading model, we document a December 1986 change in year-end trading patterns. TRA 86 also had long-term effects on individual investors’ trading decisions. The results suggest that individual investors were less (more) willing to sell accrued gain (loss) stocks after TRA 86. Our ability to document predicted trading behavior is in part due to our trading metric, which captures individual investors’ selling activity better than the volume-based metrics used in prior research.

How Do Taxes Affect Investors' Stock Market Realizations? Evidence from Tax-Return Panel Data

This article provides direct evidence on the empirical importance of tax-reduction strategies. The authors' results indicate that relatively few investors trade securities to reduce their taxes and that tax-induced trading has little effect on stock prices. Their findings suggest that, holding all else constant, stock prices are likely to be insensitive to the difference between short- and long-term capital gains tax rates. Copyright 1994 by University of Chicago Press.

Tax-Induced Trading and the Turn-of-the-Year Anomaly: An Intraday Study

Tax-Induced Trading and the Turn-of-the-Year Anomaly: An Intraday Study

Grandfather Clauses and Optimal Portfolio Revision

Introduction Adverse changes in the tax treatment of particular securities are often accompanied by grandfather clauses that shield existing holders from the changes. If these holders consider selling their positions, they should realize that any repurchases of these securities will be subject to the new, more severe tax law. By focusing on a particular provision in the Tax Reform Act of 1986, this article illustrates how to derive an optimal investment policy in the presence of grandfather clauses. The Tax Reform Act of 1986 required property-liability insurers to reduce their tax deductions for losses by 15 percent of their tax-free income,(1) effectively raising their marginal tax rate on tax-exempt income. A grandfather clause stated that the rule applies only to income from tax-exempt bonds purchased after August 8, 1986. Effects of this change are quite important: From 1986 to 1989, over 30 percent of property-liability insurers' financial assets were in tax-exempt bonds, and these insurers held about 16.4 percent of all tax-exempt bonds outstanding (Board of Governors of the Federal Reserve System, 1990). The literature relating tax law to investment policy grew along two branches. The first derived tax-induced trading strategies under the assumption that all investors are taxed alike. For example, Constantinides (1983, 1984) and Constantinides and Ingersoll (1984) analyzed optimal deferral and realization of capital gains and losses in stock and bond markets. The second branch focused on the fact that not all investors are taxed alike. Schaefer (1982) showed that differentially taxed investors usually disagree on the relative value of securities and, consequently, choose to hold different sets of securities. Furthermore, the set of securities held by any class of investors may very well change over time. Subsequent work (e.g., Dybvig and Ross, 1986; Dammon and Green, 1987; Dermody and Prisman, 1988) analyzed equilibrium prices in the presence of differential taxation. The analysis here differs from both of these approaches. Whereas the first branch studied tax-induced trading in a particular asset, this article analyzes tax-induced trading across assets. And while the second branch studied the equilibrium implications of differential taxation, this article assumes that price movements can induce differentially taxed investors to switch from one asset to another in order to focus on an interesting investment problem. Furthermore, this is the first study of the effects of a grandfathered tax change on optimal trading strategies. The next section formalizes the investment problem of a property-liability insurer that holds exempt bonds bought before August 8, 1986. Then, using historical parameters, we show that the value of the option to switch between bond classes and the value of the grandfather clause have nontrivial magnitudes. The Model and Optimal Investment Policy This section first develops the model in the absence of capital gains taxation in order to illustrate clearly and simply the methodology and the main results. The second part of the section adds capital gains taxation to the model. No Capital Gains Taxation Assume the existence of two types of perpetuities. Both types pay $1, before taxes, each year, but the income from one type is tax-exempt, and the income from the other type is taxable. In an equilibrium characterized by differential taxation, the prices of the exempt and taxable securities will differ in a way that reflects the level of interest rates and the relative wealths of the different tax classes. Consequently, the difference between the two prices can be modeled as fluctuating randomly over time. For simplicity, we model the spread between taxables and exempts by fixing the price of the exempt perpetuity at some constant, |P.sub.E~, and letting the price of the taxable perpetuity, |P.sub.T~, fluctuate randomly. Now consider the investment decision facing a property-liability insurer. …

Tax-Induced Trading: The Effect of the 1986 Tax Reform Act on Stock Market Activity

The abolition of the favorable tax treatment of long term capital gains forced investors to reassess traditional year-end trading strategies used to manage tax liabilities. This study compares with year-end trading behavior in previous years with that observed at the end of 1986. Traditional strategies involve selling both short and long term losers and holding short and long term winners. Our results affirm previous findings concerning tax induced trading at year end. However, for 1986, we find that the anticipated tax code changes had a powerful effect on trading behavior. Compared to previous years, relative trading volume was considerably higher in December of 1986 for long term winners and lower for long term losers. Additional results indicate that traditional patterns of trading induced by short term capital gains and losses were also altered substantially in 1986.

Tax-induced trading around ex-dividend days

Abstract This paper investigates trading volume around ex-dividend days. For taxable distributions (cash dividends), it is found that trading volume increases significantly around the ex-dividend day. This increase is more pronounced for high yield, actively traded stocks and after brokerage commissions became negotiable. The results are consistent with the hypothesis that short-term traders have an impact on ex-day price behavior, at least for taxable distributions. For non-taxable distributions (stock splits and stock dividends) we find negative abnormal volume around ex-day.