Tax Management Strategies with Multiple Risky Assets

Abstract

We study the consumption-portfolio problem of a capital gain taxed investor who has access to multiple risky stocks. Primary to our analysis is to understand how costly short selling influences portfolio choice with a shorting the box restriction. Our analysis uncovers two different strategies where it is optimal to short sell. The first, identified as a trading flexibility strategy which is new in our analysis, is an ex ante way of minimizing future tax-induced trading costs. With this strategy, the investor shorts one of the stocks even when no stock has an embedded gain. The second shorting strategy is an imperfect form of shorting the box used to ex post reduce aggregate equity exposure. Given these two short selling strategies, it is common for an unconstrained investor to short some equity while a constrained investor holds a positive investment in all stocks. A similar trading flexibility strategy is implicitly present if the investor can not short but is allowed to buy put options. Somewhat surprisingly, the benefit of trading separately in the two stocks for a short sale constrained investor is not economically significant; while, on the other hand, the welfare benefit is significant for an investor who can short at a low cost or who can trade in derivatives.

Keywords: Portfolio Choice, Capital Gain Taxation, Short Sales

JEL Classification: G11, H20