Taxation and Household Asset Location and Allocation: Evidence from the Bush Tax Acts

By exploiting the structural tax rate changes created by the Bush-era tax acts in 2001 and 2003, this study offers a first direct investigation of how the differential taxation of financial assets affects households’ asset location and allocation into taxable and tax-deferred accounts in a natural experimental framework. Because bonds are heavily taxed assets, relative to stocks, and tax treatments of financial assets in tax-deferred accounts differ from those in taxable accounts under U.S. federal tax laws, households’ tax burdens vary depending on which account they use for their asset holdings. Relying on the tax arbitrage model, this study identifies optimal asset locations in taxable and tax-deferred accounts; the household should hold only assets with the heavily taxed asset (taxable bonds) in the tax-deferred account and mixed assets in a taxable account with the desired risk exposure. The empirical results, based on the Survey of Consumer Finances data, indicate that households with greater tax rate differentials between interest (bonds) and capital gains (stocks) hold significantly lower shares of bonds in taxable accounts and greater shares of bonds in tax-deferred accounts by “risk-preserving” portfolio changes. These households also hold significantly more shares of stocks in their taxable portfolio. These findings are consistent with the predictions of the tax arbitrage model, such that tax arbitrage provides profits from changing asset locations depending on the difference in tax rates between bonds and stocks, and these profits increase as the tax rate differential between bonds and stocks (i.e., the tax disadvantages of bonds relative to stocks) increases. These findings also support the idea of households’ tax-motivated asset allocation decisions, based on the after-tax capital asset pricing model (CAPM).