Since realized returns and future expected returns of financial assets tend to move along opposite directions, tax-timing incentive can be in sharp conflict with market-timing incentive. This paper studies a portfolio choice model with return predictability, and characterizes the optimal policy that jointly times market returns and capital gains taxes. The calibrated model suggests that return predictability significantly increases both the utility loss due to capital gains taxes and the value of tax-deferral, and these findings shed new light on the “asset location puzzle.” We further measure the costs of separately conducting market- and tax-timing, and examine the welfare implication of the optimal policy through an empirical simulation.

Keywords: Portfolio Choice, Return Predictability, Capital Gains Tax.

JEL Classification: G11, H24, K34.