Taxation of Capital Gains upon Accrual: Is It Really More Efficient than Realization?

Taxation of capital gains upon realisation is known to discourage the liquidation of an appreciated asset (lock-in effect), thus resulting in a distortion in portfolio choices. However, compared to taxation upon accrual, realisation-based taxation may imply a lower distortion in intertemporal allocation of consumption. In particular, we show that this is always the case when preferences are intertemporally weakly separable and homothetic. Using a simple model of intertemporal choice, we assess and compare the distortions induced by the two tax regimes of accrual-based and realisation-based taxation of capital gains. Our numeric simulations show that, for reasonable values of the parameters, realization-based taxation can in fact imply a lower overall distortion of investment choices, hence no clear ranking of the two systems is possible in general. Additionally, we find that the differences in efficiency, in either direction, is likely to be very small.