Diversification and Taxes: Evidence from the Taxation of Capital Gains and Losses

Richard J. Rendleman
University of North Carolina

Douglas A. Shackelford
The University of North Carolina at Chapel Hill

Abstract: This paper employs option pricing theory to analyze the stock valuation implications created by this pooling of capital gains and losses. We find that the impact of capital gains taxation on stock values can be positive or negative depending on the correlation between the stock’s returns and those of the overall portfolio. Specifically, valuations for stocks whose returns are positively (negatively) correlated with the portfolio returns generally are decreasing (increasing) in capital gains tax rates. This implies that the prices of securities that move against the market should incorporate a premium due to the netting of capital gains and losses. Other findings in this paper include stock values varying with the rate of dividend growth for the stock compared with that of the portfolio, the level of interest rates, and the extent of risk aversion reflected in equity prices.

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