The behavior heuristics responsible for formation and liquidation of tax holding accounts

Abstract

This article proposes the tax liquidation hypothesis, a predictable pattern of behavior regarding individuals’ decisions to create and subsequently to liquidate “Cash Holding” accounts when facing tax liabilities. Previous research on tax related trading has focused on minimizing the individual tax burden by holding winners and selling losers. This behavior, described as “optimal tax trading” suggests that individuals should sell stocks that have lost value in the short-term while holding onto stocks that have gained value until the stocks can be sold at the preferential long-term capital gains rate. This article proposes the tax liquidation hypothesis based on investor behavioral biases and the current tax environment. Individual investors will hold “cash” accounts that are consistent with their preferences for risk and return. The cash account holdings may differ across individuals, but the pattern and hypotheses regarding formation and liquidation of these accounts for tax reasons should be consistent with the model proposed by this article.