Capital gains taxes and optimal trading
Coauthor(s): Mattia Landoni
Capital gains taxes are a well known cost of trading. However, the actual “tax cost” of selling appreciated assets is often negligible and sometimes even negative, because depreciation or amortization allowances create an offsetting subsidy. No allowance exists for stocks, making investors reluctant to realize gains (the “lock-in effect”). For most other assets, however, investors should feel indifferent or even happy about paying capital gains taxes. I predict that property and casualty insurers are mildly reluctant to sell appreciated taxable bonds, but very reluctant to sell appreciated tax exempt bonds. Because of premium amortization, selling appreciated taxable bonds is cheap: one dollar of gain realized today is matched by a one-dollar reduction in the taxable part of future interest income. Selling appreciated tax-exempt bonds, however, is expensive: capital gains are taxable, but premium amortization is worthless because interest is already tax-exempt. I confirm my prediction using regulatory filings that contain book value, fair value, and transactions for all insurers' bond positions. Taxes are a first-order factor in the decision (not) to sell appreciated tax-exempt bonds in the period leading up to the financial crisis; during the crisis, however, trading motives other than taxes prevail temporarily.
Mattia Landoni "Capital gains taxes and optimal trading." , Columbia Business School, (2013).