Optimal Consumption and Investment with Asymmetric Long-term/Short-term Capital Gains Taxes

We propose an optimal consumption and investment model with asymmetric longterm/short-term tax rates for a small investor. We also consider both the case where an investor can get full tax rebate for capital losses and the case where the investor can only carry over capital losses. The full rebate case is a better model for low income investors while the carry over case is more suited for wealthy investors. The optimal trading strategy is characterized by a time-varying no-transaction region outside which it is optimal to realize capital gain or loss to achieve the optimal fraction of after-tax wealth invested in stock. We show that the optimal consumption and investment policy is qualitatively different from what is found in the standard literature and the optimal policy for low income investors is qualitatively different from that for wealthy investors. More specifically, for low income investors, (1) it can be optimal to defer capital loss realization beyond one year even in the absence of transaction costs and wash sale restriction; (2) it can be optimal to defer long-term capital gains even when the rebate rate for short-term losses is high; (3) raising the short-term tax rate can significantly increase both consumption and stock investment; (4) higher tax rates (such those for wealthy investors) can make them significantly better off.