The Effect of Tax Rates and Transaction Costs on the Tax Trading Option: Evidence from Stock Splits

Abstract

Previous research suggests that investors' timing option on the realization of capital gains and losses is valuable when long-term and short-term capital gains tax rates differ. Prior studies simulate returns to a variety of tax strategies and find that the benefits of the tax trading option are sensitive to investors' assumed trading behavior as well as to tax rates, transaction costs, and stock price variances. However, the historical effects of changes in these conditions have not previously been estimated. In this study, we use the stock return variance changes that typically accompany stock splits to examine the effects of tax rates, transaction costs, and interest rates on the value of the tax trading option. Our results suggest an increase in the value of the tax option when trading costs declined after the 1975 elimination of fixed commissions. We also find evidence of a substantial reduction in the value of the tax option when the gap between short-and long-term capital gains tax rates was reduced in 1982.