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Rev Fin 2001; 14:583-616
© 2001 the Society for Financial Studies

Optimal Consumption and Investment with Capital Gains Taxes

Robert M. Dammon and Chester S. Spatt
Carnegie Mellon University

Harold H. Zhang
University of North Carolina at Chapel Hill

Abstract

This article characterizes optimal dynamic consumption and portfolio decisions in the presence of capital gains taxes and short-sale restrictions. The optimal decisions are a function of the investor's age, initial portfolio holdings, and tax basis. Our results capture the trade-off between the diversification benefits and tax costs of trading over an investor's lifetime. The incentive to rediversify the portfolio is inversely related to the size of the embedded gain and investor's age. Contrary to standard financial advice, the optimal equity holding increases well into an investor's lifetime in our model due to the forgiveness of capital gains taxes at death.


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