Taxation and Household Portfolio Behavior

By Poterba, James M. | NBER Reporter, Spring 2004 | Go to article overview
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Taxation and Household Portfolio Behavior

Poterba, James M., NBER Reporter

The personal income tax has a critical effect on the rate of return that households earn on their investments. Taxes reduce the rate of return, and they do so to different degrees for different assets. Assets that generate mostly capital gains, for example, historically have faced lower tax burdens than those that generate either interest or dividend income. Assets that are held in tax-deferred retirement savings accounts, such as Individual Retirement Accounts or 401(k) plans, face lower tax burdens than assets that are held outside such accounts.

Much of my recent research has explored the impact of income tax rules on household portfolio behavior. Investigating whether households recognize the incentives that are built into the income tax code, and then studying whether they change their behavior in response to these incentives, is one of the perennial research missions of empirical public economics. Investigating these issues in the portfolio choice setting is particularly attractive because the tax rules are reasonably clear and subject to frequent change. Many of the behavioral changes that one might expect in response to capital income taxes, such as selling assets with accrued losses or holding tax-exempt rather than taxable bonds, are also easier to implement than the behavioral changes that might be associated with tax incentives for labor supply or homeownership.

Households may choose to invest in a wide array of financial assets, and there are often asset-specific tax rules that determine the relationship between pretax and aftertax returns. Part of my research has focused on taxpayer response to specific tax rules on particular classes of assets, while another part has explored more broadly how the structure of household portfolios, and the allocation of portfolio assets between taxable and tax-deferred accounts, is affected by taxation.

Capital Gains Taxation and Investor Behavior

The capital gains tax is one of the most widely-studied components of the U.S. tax code. Because gains are taxed only when they are realized, investors have some control over their tax burden. By delaying the sale of an asset that has increased in value, investors can defer their capital gains tax and thereby reduce the present discounted value of their tax liability. Conversely, by realizing a loss as soon as it accrues, an investor can benefit immediately from any tax relief that may be provided on loss realizations. A critical issue in the design of the capital gains tax is the extent to which capital gains taxation distorts trading behavior by taxable investors.

Zoran Ivkovich, Scott Weisbenner, and I (1) have investigated capital gains lock-in using data on individual brokerage account transactions. We compare the trading decisions of individuals who own both taxable and tax-deferred accounts. Since the capital gains tax affects gains and losses realized in the taxable account, but not those in tax-deferred accounts such as IRAs and Keogh plans, we can test whether taxes affect trading behavior. We find pronounced differences in trading between the two accounts. While there is a high degree of turnover in both accounts in the first few months after a stock is purchased, we find that by six months after purchase, realization probabilities for gains in the taxable account are substantially below those for tax-deferred accounts. We also find that losses are more likely to be realized if they occur in a taxable account rather than a tax-deferred account.

"Basis step-up at death" is an aspect of the current capital gains tax that figures prominently in the estate planning and asset trading decisions of many investors, particularly those at advanced ages. The tax on capital gains that accrue during an investor's lifetime, but are never realized, are not taxed if the assets are bequeathed to another individual. The tax basis in such assets is "stepped up" to the market value at the time of death.

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