Do Capital Gain Tax Rate Increases Affect Individual Investors' Trading Decisions?

Contrary to the mixed evidence reported in prior studies that utilize volume-based metrics to examine the effect of taxes on short-term (Bolster et al., 1989; Henderson, 1990) and long-term (Henderson, 1990; Ricketts and Walter, 1997) trading activity, this study finds strong evidence that individual investors' short- and long-term reactions to TRA 86's capital gain tax rate increase were consistent with a tax-induced model of investor trading. Specifically, we find that individual investors' selling activity in stocks with long-term accrued gains (losses) was higher (lower) in December 1986 than in previous Decembers. With respect to TRA 86's permanent effects, we find that TRA 86's capital gain tax rate increase reduced (increased) individual investors' selling activity in stocks with long-term accrued gains (losses).Our ability to document trading behavior consistent with economic theory is in part due to our transaction-based trading metric which, compared to volume-based metrics utilized in prior research, better captures individual investors' selling activity. In addition to documenting evidence that taxes affect individual investors' trading decisions, the study suggests that research examining the effect of taxes on investment decisions should exploit tax law changes as a means of isolating tax effects from non-tax effects. Finally, given the evidence in this study, future research should examine how taxes affect information-related trading decisions