Panel Paper: A Markov Chain Analysis of Capital Gains Realizations: The Great Recession Versus the 2001 Recession

Friday, November 9, 2012 : 8:40 AM
Jefferson (Sheraton Baltimore City Center Hotel)

*Names in bold indicate Presenter

James Pearce, US Department of Treasury and Ithai Lurie, U.S. Department of the Treasury

One common feature of the past two recessions (2001and 2008) is a substantial decline in equity valuations.  The timing of these declines was very different, however.  While the S&P 500 declined 13% in 2001 and an additional 23% in 2002, it declined by 38% in 2008 and actually increased by 23% in 2009.  Individual decisions to sell stock are greatly affected by stock market movements, so the difference in this timing may have affected individual decisions. Surprisingly, aggregate tax data shows that net capital gains realizations in adjusted gross income (AGI) dropped by about 48% in the first year of each recession (2000-2001 and 2007-2008). Capital gains realizations in AGI differ significantly in the second year of the two recessions, decreasing only 27% between 2001 and 2002 compared with 51% between 2008 and 2009.

In this paper we examine changes in capital gains realizations from a longitudinal perspective using a Markov Chain model. Using a panel of tax returns from 1999-2009, we use the Markov chain framework to model transition probabilities between three states: positive capital gain realizations, zero capital gain realizations, and negative capital gain realizations.  The transition probabilities between these three states were very similar prior to both the 2001 and 2008 recessions.  For example, the continuation rate for positive capital gains was 72.7% in 2000 and 74.3% in 2007, while the continuation rate for capital losses was 51% in 2000 and 59% in 2007.  The transition probabilities were also similar in the first year of both recessions, each showing a substantial decrease in the continuation rate for positive capital gains (49% in 2001 and 43% in 2008) and a substantial increase in the continuation rate for capital losses (63% in 2001 and 71% in 2008).  The transition probabilities differ more in the second year the two recessions.  Specifically, the continuation rate for taxpayers with positive capital gains declined only a little in 2002 (to 41%) but declined substantially in the Great Recession to 29.5% in 2009.  The 2009 exit rate from positive capital gains to zero realizations was about 10 percentage points higher than in 2002, while the exit rate from capital gains to losses were similar in 2002 and 2009.  We find no statistically significant difference in entry rates from either capital losses to capital gains or from no realization to capital gains in the second year of the two recessions.

The difference in the continuation rate for positive capital gains in the second year of the two recessions is somewhat surprising given that the stock market began to recover in 2009 while the stock market declined through 2002.  The results suggest that the quicker decline in the stock market in 2008 relative to 2001 caused taxpayers to sell a greater amount of securities at a capital loss.  In fact, capital loss carry-forwards from 2001 to 2002 were only $233 billion dollars compared with over $500 billion from 2008 to 2009.