Diversification and the Taxation of Capital Gains and Losses

Current U.S. law nets the total portfolio of realized capital gains and losses to compute capital gains taxes. Prior research, however, typically ignores the implication of this provision, i.e., the marginal tax rate for a specific gain or loss depends on the taxpayer's total portfolio of realized gains and losses. We find that these nettings introduce complexity into the relation between share values and capital gains taxes, creating an incentive to diversify. For firms with stock returns that are positively (negatively) correlated with those of the overall market, share values generally are decreasing (increasing) in the capital gains tax rate.