The Only Sure Alpha: Tax-Motivated Trading and Price Efficiency

Abstract

This article addresses how tax rules shape price discovery in financial markets. Price discovery, the process by which new information about the fundamental value of an asset is incorporated into its price, is a critical feature of financial markets. Tax rules distort the price discovery process by incentivizing trading that is based on tax considerations rather than information about fundamental value. Indeed, tax-motivated trading strategies have been described as “the only sure alpha”—the only way that investors can reliably beat the market return. Tax-motivated trading is “noisy”: it causes asset prices to temporarily deviate from their fundamental value. Noisy trading interferes with market signals about how best to allocate investment capital. In addition to explaining how tax rules distort the price discovery process, this article considers whether several features of tax law might mitigate the distortions introduced by tax-motivated trading. It then evaluates different options for reforming the current system for taxing financial instruments in order to eliminate those distortions.