Capital Gains Tax Rules, Tax Loss Trading and Turn-of-the-Year Returns

Abstract

This paper investigates the effect of specific features of the U.S. capital gains tax on turn-of-the-year stock returns. It focuses on two tax changes. The first, enacted in 1969, reduced the fraction of long-term losses that were deductible from Adjusted Gross Income from 100 percent to 50 percent. The second, part of the Tax Reform Act of 1976, raised the required holding period for long-term gains and losses from six months to one year. This paper describes how each of these tax changes should have affected incentives for year-end capital loss realization and the potential magnitude of the turn of the year effect in stock returns. We present evidence that is consistent with the hypothesis that detailed provisions of the capital gains tax, such as the short-term holding period, affect the link between past capital losses and turn-of-the-year stock returns. These findings provide support for the role of tax-loss trading in contributing to turn-of-the-year return patterns.