Methods of Capital Gains Taxation and the Impact on Asset Prices and Welfare

Taxation of capital gains upon realization instead of accrual provides incentives to hold winners as long as possible and sell losers immediately. This so–called lock–in effect possibly distorts the liquidation and investment decision and, hence, is usually regarded as harmful. This paper analyzes the impact the method of taxation has on asset prices and welfare within a simple general equilibrium model of an exchange economy with heterogeneous agents. It is shown that asset prices are higher under a realization–based tax system than under an accrual one. However, due to distributional effects, total welfare is not necessarily lower.