Capital gains tax rules, tax-loss trading, and turn-of-the-year returns

Changes in the capital gains tax rules facing individual investors do not a ffect the incentives for "window dressing" by institutional investors, but they can affect the incentives for year-end tax-induced trading by individu al investors. Empirical evidence for the 1963 to 1996 period suggests that when the tax law encouraged taxable investors who accrued losses early in t he year to realize their losses before year-end, the correlation between ea rly year losses and turn-of-the-year returns was weaker than when the law d id not provide such an early realization incentive. These findings suggest that tax-loss trading contributes to turn-of-the-year return patterns.