Previous theoretical analyses of the capital gains tax have suggested that investors have considerable opportunity to avoid the tax. Yet, past empirical work has found relatively little evidence of such activity. Using a previously unavailable panel data set with a very large sample of high-income individuals, this paper aims to bring the theory and evidence closer together by examining the behavior of individual taxpayers over time.Though confirming past findings that avoidance of tax on realized capital gains is not prevalent, we do observe that tax avoidance activity increased after the passage of the Tax Reform Act of 1986, and that high-income, high-wealth and more sophisticated taxpayers were most likely to avoid tax. However, the efficacy of tax avoidance strategies depends on being able to avoid tax for long periods, and we find that most tax avoidance is of relatively short duration.Thus, the effective tax rate on realized capital gains is very close to the statutory rate in all years and tax brackets.
This paper attempts to bring theoretical and empirical research on capital gains realization behavior closer together by considering whether investors who appear to engage more in strategic tax avoidance activity also respond differently to tax rates. We find that such investors exhibit significantly smaller responses to permanent tax rate changes than other investors. Put another way, a larger part of their response to capital gains tax rates reflects timing, consistent with their closer adherence to tax avoidance strategies emphasizing arbitrage based on tax rate differentials. This finding holds for two alternative specifications of realization behavior, one of which suggests larger permanent responses to capital gains tax rates than those of previous panel studies.
This paper attempts to bring theoretical and empirical research on capital gains realization behavior closer together by considering whether investors who appear to engage more in strategic tax avoidance activity also respond differently to tax rates. We find that such investors exhibit significantly smaller responses to permanent tax rate changes than other investors. Put another way, a larger part of their response to capital gains tax rates reflects timing, consistent with their closer adherence to tax avoidance strategies emphasizing arbitrage based on tax rate differentials. This finding holds for two alternative specifications of realization behavior, one of which suggests larger permanent responses to capital gains tax rates than those of previous panel studies.
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