Question

Short term capital gains taxes are higher than long term capital gains taxes. How does the different tax treatment impact the estimates of alpha in the CAPM model?

Answer 1

The CAPM model calculates the required rate of return on the basis of the systematic risk of the stock, that is beta and it measures risk in relation to the stock market. The alpha is the excess return that is generated over the required return according to the CAPM.

Alpha = Estimated return – (risk free rate + beta*(Market return -risk free rate))

Here the estimated return can differ depending on the market scenario assuming the markets are inefficient.

If the markets are inefficient then there is possibility that there will be alpha in the market, if short-term gains are taxed at ordinary rates which is normally higher than the capital gains tax rate then the estimated return would be reduced from the security however the traditional CAPM model assumes the tax rate to be zero but in real world scenario your estimated return would be reduced and so would be the alpha.