Capital gains tax rules, tax loss trading, and turn-of-the-year returns, National Bureau of Economic Research Working paper 6616

Changes in the capital gains tax rules facing individual investors do not affect the incentives for “window dressing ” by institutional investors, but they can affect the incentives for year-end tax-induced trading by individual investors. Empirical ev-idence for the 1963 to 1996 period suggests that when the tax law encouraged taxable investors who accrued losses early in the year to realize their losses before year-end, the correlation between early year losses and turn-of-the-year returns was weaker than when the law did not provide such an early realization incentive. These findings suggest that tax-loss trading contributes to turn-of-the-year return patterns. A VARIETY OF EXPLANATIONS have been offered for the unusual behavior of stock returns at the turn of the calendar year. Some focus on the annual cash f low patterns to institutional investors, others focus on the incentives that year-end reporting requirements place on these investors, and others suggest that the income tax system facing individual investors may induce tax-motivate