Tax-Induced Trading: The Effect Of The 1986 Tax Reform Act

The most sweeping revision of the US tax code in many years became law in September 1986 with passage of the Tax Reform Act of 1986. An important aspect of the law was the elimination of the favorable tax treatment of long-term capital gains. The nearly 4-month lag between passage of the Act and the effective data of the tax change gave investors ample opportunity to assess the law's consequences for their portfolios and to adjust their behavior accordingly. Trading behavior in December 1986 and January 1987 is compared with previous years, using using monthly trading volume and price data for a large sample of firms over the period 1980-1987. The results show that the tax code changes had a powerful effect on trading behavior. Relative trading volume was found to be considerably higher in December 1986 for long-term winners but not significantly lower for long-term losers. The results also show altered trading patterns based on short-term gains in December 1986 and for long-term winners in January 1987.