An Empirical Investigation of the Relation between Tax-Loss Selling and the January Effect.

Abstract This study tests the tax-loss-selling hypothesis as an explanation of the "January effect." The hypothesis is tested by examining the price growth rate in commodity futures contracts before and after the enactment of the Economic Recovery Tax Act of 1981 (ERTA). ERTA requires investors to recognize for tax purposes the unrealized gain or loss on commodity futures contracts at year-end. This tax treatment effectively removes the motivation for investors to sell commodity futures for tax purposes after 1981. The tax-loss-selling hypothesis predicts that the January effect is present in commodity futures contracts with high tax-loss-selling potential prior to ERTA but disappears after the enactment of ERTA. It also predicts that the January effect is not present in commodity futures with low tax-loss-selling potential either before or alter the enactment of ERTA. The study finds support for the tax-loss-selling hypothesis as an explanation of the year-end effect observed in the commodities market prior to the enactment of ERTA.