Thursday, November 24, 2011
The current capital gains tax law stipulates that the tax rate for short-term investment (gains and losses) and long-term losses is equal to an investor's marginal ordinary income tax rate, which implies that this rate for low income investors can be significantly lower than that for high income investors. In an optimal consumption and investment model with asymmetric long-term/short-term tax rates, we show that even though capital gains tax rates for low income investors are always lower than those for high income investors, the current capital gains tax law is significantly biased against low income investors in the sense that these investors are willing to pay a substantial fraction of their initial wealth to gain the same capital gains tax treatment as high income investors have. The main reason is that investors have the option of realizing capital losses at the (higher) marginal ordinary income tax rate and realizing capital gains at the (lower) long-term tax rate and the value of this option is significantly lower for low income investors than that for high income investors. This result is robust to various changes in model parameter values. Raising capital gains tax rates for low income investors to the levels for high income investors would reduce the bias and substantially increase stock market participation by low income households. With regard to the optimal tax realization strategy, in sharp contrast to most of the existing literature, we show that it can be optimal to defer short-term capital losses beyond one year and to realize short-term gains.