This PDF is a selection from an out-of-print volume from the National
Bureau of Economic Research
Volume Title: Tax Policy and the Economy, Volume 14
Volume Author/Editor: James M. Poterba, editor
Volume Publisher: MIT Press
Volume ISBN: 0-262-66164-0
Volume URL: http://www.nber.org/books/pote00-2
Publication Date: January 2000
Chapter Title: Stock Market Reaction to Capital Gains Tax Changes:
Empirical Evidence from the 1997 and 1998 Tax Acts
Chapter Author: Douglas A. Shackelford
Chapter URL: http://www.nber.org/chapters/c10847
Chapter pages in book: (p. 67 - 92)
Stock Market Reaction to
Capital Gains Tax Changes:
Empirical Evidence from the
1997 and 1998 Tax Acts
Douglas A. Shackelford
University of North Carolina and NBER
EXECUTIVE SUMMARY
This paper analyzes the impact of changes in capital gains taxes on
equity values. Seven necessary conditions are outlined for stock prices to
be affected by a change in the taxation of long-term capital gains. Specifi-
cally, the marginal investor must be an individual, investing for the
requisite holding period, selling in a taxable disposition, and compliant.
His short-term capital gains from all investments equal or exceed short-
term capital losses, and his long-term capital gains from all investments
equal or exceed long-term capital losses. In addition, the capital gains tax
change must alter the investor's expectation of the taxes that wifi be
generated when he sells in the future, and inelasticities in the supply of
capital must prevent immediate economic readjustment.
The paper then reviews four studies that estimate the stock market
reaction to capital gains tax changes in the Taxpayer Relief Act of 1997
and the Internal Revenue Service Restructuring and Reform Act of 1998.
The recency of these legislative changes and the conditions under which
they were enacted provide useful settings for recalibrating the relation
between stock prices and capital gains taxation.
This paper has benefited from comments by Jennifer Blouin, Jim Poterba, and Jana Raedy.
68
Shackelford
Although evaluating different firms and event periods, the studies
generally find:
Stock prices react to changes in the capital gains tax policy.
Stock prices react quickly to information about tax legislation.
The stock price reaction is largely complete by public announcement
of the change.
The magnitude of the stock price reaction is material.
These findings join a growing literature documenting that capital gains
tax policy plays a role in establishing equity values.
1. INTRODUCTION
Capital gains tax policy has entered a new phase of legislative uncer-
tainty. From 1987 to 1997, individuals faced a maximum U.S. statutory
capital gains tax rate of 28 percent on investments held for more than
one year. Since then, Congress has reduced the long-term capital gains
tax rate and adjusted the holding period twice.
The Taxpayer Relief Act of 1997 (TRA 97), which became law on August
5, 1997, lowered the maximum statutory long-term capital gains tax rate
for individuals from 28 to 20 percent, effective May 7, 1997. After July 28,
1997, the lower rate was restricted to property held for more than 18
months. Investments held for more than 12 months, but not more than
18 months, faced the 28 percent tax rate. TRA 97 did not change the rate
applied to investments held for one year or less. They continued to be
taxed at the ordinary income tax rate, which caps at 39.6 percent.
The 18-month holding period was short-lived. On July 22, 1998, the
Internal Revenue Service Restructuring and Reform Act of 1998 (IRSREA
98) repealed the 18-month holding period, effective January 1, 1998.
Thus, investors currently enjoy a maximum 20 percent long-term capital
gains tax rate on all purchases held for more than a year.
This summer Congress attempted to reduce the long-term rate fur-
ther. On August 5, 1999, Congress passed the Taxpayer Reform and
Relief Act of 1999, which would have reduced the maximum individual
capital gains tax rate to 18 percent, effective January 1, 1999. Although
President Clinton vetoed the bifi on September 23, 1999, speculation
remains that a compromise bifi may materialize.
With each of these legislative initiatives, there has been no consensus
about the impact of the capital gains tax legislation on stock prices. For
example, in 1997, many predicted the reduction of the capital gains tax
rate would spur savings and investment, ultimately increasing stock val-
Reaction to Capital Gains Tax Changes
69
ues, though perhaps preceded by an initial sell-off. Some doubted the cut
could spur an already record-level stock market. Others foresaw disaster.
For example, columnist John Rothchild (Fortune, April 28, 1997,
p. 409)
called the rate reduction, "the worst thing to happen to the stock market
since Saddam Hussein invaded Kuwait." David Jones, analyst at Aubrey
G. Lanston, summarized the confusion: "There's a huge amount of uncer-
tainty about thishow much selling there wifi be, how much revenue
generated, what the effect wifi be on stocks" (Boston Globe, June 22, 1997,
p. E7). The same article quotes Brookings economist William C. Gale
stating, "I can't venture a guess" about whether the cut wifi increase or
decrease stock prices. A purpose of this paper is to sharpen forecasts of
the stock price effects of future capital gains tax changes on stock prices by
analyzing the conditions required for such changes to affect stock prices
and reviewing initial research evaluating the 1997 and 1998 Acts.
Before this recent flurry of legislative action, the previous two
changes in capital gains tax rates occurred in the Tax Reform Act of 1986
and the Economic Recovery Tax Act of 1981. Neither act provides a
powerful setting for evaluating the stock market reaction to capital gains
tax changes. Their development and complexity impede attempts to
isolate those responses. Both involved months of debate and substantial
restructuring of the tax system.
In contrast, the 1997 and 1998 changes to capital gains taxation poten-
tially provide unusually powerful settings to isolate price effects. Nei-
ther bifi was as comprehensive, as complex, or as controversial as the
1981 and 1986 Acts. With both bills, information about the capital gains
tax changes appear to have been conveyed to the equity markets during
a brief period, causing the stock market to adjust quickly its expectations
about the probability of a change. If so, this facilitates isolation of the
stock market reaction to capital gains tax changes, because prices should
have impounded the changes during a narrow window.
An additional advantage of examining the recent Acts is that economic
and technological changes (e.g., reduced brokerage fees and expanded
use of stock options) since the 1980s have potentially altered the benefits
of favorable long-term capital gains treatment for the stock markets. In
particular, more individuals (the sole group benefiting from favorable
long-term capital gains tax rates) now invest in equity, and their hold-
ings are greater. As a result of the bull market, many shares are highly
appreciated, subject to substantial capital gains taxes. Consequently,
personal capital gains taxation may be more important in equity price
formation now than in the past.
Recognizing the opportunity to recalibrate the relation between share
prices and capital gains tax changes, four studies have assessed the stock
70
Shackelford
market reaction to the 1997 and 1998 Acts. Each analysis
employs event
study methodology. Firm-level price reactions are examined using
research
designs that assess differences in share price responses across
firms. The
tests control for indirect macroeconomic factors that
affect all sectors.
Three studies evaluate share price responses during the development
of TRA 97 and following its enactment. Lang and Shackelford
(2000) find
that when Congress and the White House agreed to cut the
capital gains
tax rate in May 1997 (three months before the
bill's passage), returns on
high-dividend-yield stocks were lower than those on stocks with lower
dividend yields. They interpret these findings as evidence that investors
discriminated among companies based on the probability that share-
holder returns would be affected by the new capital gains tax rates.
Sinai and Gyourko (1999) test whether investors discriminated between
real estate investment trusts (REITs) organizational forms based on the
potential tax savings to individuals selling real estate. Consistent
with the
capital gains rate reduction lowering the cost of purchasing real estate,
they find that in 1997 traditional REITs outperformed acquisitive
UPREITs
(an organizational form that benefited less from the rate reduction).
Guenther (1999) also investigates TRA 97. He seeks to determine
whether individual shareholders deferred selling appreciated stock until
the effective date for the lower rate was finalized. Consistent
with a
sellers' strike, Guenther finds lower ex-dividend day returns
immedi-
ately preceding the effective date.
Blouin, Raedy, and Shackelford (1999b) evaluate the stock price effects
of the IRSRRA 98 reduction in the long-term capital gains holding pe-
riod. They find that appreciated firms whose initial public shareholders
met the 12-month holding period, but not the
18-month period, un-
derperformed during the conference committee's deliberations that first
proposed repeal of the 18-month period. They conclude that shortening
the holding period triggered a sell-off that depressed share prices.
Overall, the evidence in these studies is consistent with the personal
taxation of capital gains affecting individual firms' prices.
The results
imply that stock prices respond to capital gains tax changes as
though
equity values capitalized anticipated capital gains taxes. In
addition, the
response is large, quick, and often complete
by public announcement of
the change.
The next section reviews the taxation of capital gains and losses.
Section
3 outlines seven necessary conditions for capital gains taxes to
affect stock
prices. Section 4 models the stock-price effect of a change in
the capital
gains tax rate. Section 5 presents results from the three studies
of TRA 97.
Section 6 discusses results from the study of the IRSRRA 98.
Section 7
draws four inferences from the studies. Closing remarks follow.
Reaction to Capital Gains Tax Changes
71
2. INDIVIDUAL TAXATION OF CAPITAL GAINS
AND LOSSES
Individual investors are taxed differently on the sale of capital assets,
depending on the length of time that they hold the property. Gains and
losses from sales of property held longer than the specified holding
period are long-term. All other realizations are short-term. Table 1 shows
that over the last forty years, the holding period required for long-term
classification has ranged from 6 to 18 months. In all years, except 1998-
1990 (when no differential existed), long-term capital gains have been
tax-favored compared with short-term capital gains. From 1970 through
1986, short-term capital losses were tax-favored compared with the long-
term capital losses because investors could deduct only half of their long-
term capital losses.
Computation of the taxable income arising from capital transactions
involves two separate nettingsshort-term capital gains netted against
short-term capital losses, and long-term capital gains netted against
long-term capital losses. If short-term capital gains exceed short-term
capital losses and long-term capital gains exceed long-term capital
losses, no further computations are required. The applicable tax rate for
short-term capital gains applies to the net short-term capital gains (i.e.,
short-term capital gains less short-term capital losses), and the applica-
ble tax rate for long-term capital gains applies to the net long-term capital
gains (i.e., long-term capital gains less long-term capital losses).
Table 1, colunm (1), shows the change in marginal tax rates when
a
stock shifts from short-term to long-term, assuming the nettings yield
both net short-term capital gains and net long-term capital gains. For
example, under current law, if a one-dollar gain (loss) is recognized
on
property held one year or less, taxes increase (decrease) by 39.6 cents. If a
one-dollar gain (loss) is recognized on property held more than
one year,
taxes increase (decrease) by 20 cents. Thus, when the stock shifts from
short-term to long-term, the marginal tax rate applied to a realization
changes by 19.6 percentage points [bottom row of Table 1, column (1)1.1
Likewise, if the two nettings yield both net short-term capital losses and
net long-term capital losses, the applicable deduction rate for short-term
capital losses applies to the net short-term capital losses, and the applica-
ble deduction rate for long-term capital losses applies to the net long-term
The gain or loss from the potential realization is assumed not to alter the overall gain or
loss position. If the investment being evaluated would create sufficient gain or loss to alter
the overall position, the marginal tax rate calculation becomes endogenous to the decision,
and the analysis is beyond the scope of this paper.
TABLE 1
Change in Marginal Tax Rate for an Individual Investor in Highest Statutory Tax Rate when Stock Qualifies
for Long-Term Treatment
(1)
Statutory
(2)
(3)
(B)
Change in
marginal tax
rate when
stock goes
tax rate: Statutory
Effective
(A)
long-term:
(C)
Holding
short-term
tax rate:
tax rate: If LTGLTL
If LTGLTL
For all other
period
gain (STG)
long-term
long-term
and STGSTL:
and STGSTLO')
combinations of
Date of sale
(mo)
or loss (STL)
gain (LTG)
loss (LTL)(a)
(1) - (2)
(1) - (3)
LTG, LTL, STG, STL
1961-1963
6
91
45.5 91
45.5
0
0
1964
6
77
38.5
77
38.5
0
0
1965-1967
6
70
35
70
35
0
0
1968-1969
6
77
38.5
77
38.5
0
0
1970
6
71.75
35.875
35.875
35.875
35.875
0
1971-1976
6
70
35
35
35
35
0
1977
9
70
35
35
35
35
0
1/1/7'S-10/31/78
12
70
35
35
35
35
0
11/1/28-12/31/81
12
70
28
35
42
35
0
1/1/82-12/23/84
12
50
20
25
30
25
0
The effective rate for long-term losses is the statutory rate in all
years except 1970-1986, when only half of net long-term capital losses could be deducted. Thus, in
those years, the effective rate is half of the statutory rate.
The maximum annual capital-loss deduction for individuals is $2000 in 1977, $1000
in earlier years, and $3000 in later years. Additional capital losses are carried
forward indefinitely. Thus, if total capital losses less total capital gains exceed the annual limit
the marginal rate is reduced depending on the carryforward utilization
period, and altered depending on the applicable rate in the year of utilization.
The holding period shifted from 12 to 6 months, effective for assets purchased after June 22, 1984. Thus,
the holding period for property sold during this time period
varied depending on the acquisition date.
The holding period shifted from 6 to 12 months, effective for assets purchased after December 31, 1987.
Thus, the holding period for property sold during this time
period varied depending on the acquisition date.
The long-term tax rate on property held more than 12 months, but less than 18 months,
was 28 percent.
12/24/84-6/22/85
6 or 12(c)
50
20
25
30
25
0
6/23/85-12/31/86
6
50
20
25
30
25
0
1987
6
38.5
28
38.5
10.5
0
0
6 or 12'
28
28
28
0
0
0
1/2/-12/31/
12
28
28
28
0
0
0
1991-1992
12
31
28
31
3
0
0
1/1/93-5/6/W 12
39.6
28
39.6
11.6
0
0
5/7/W-7/28/97
12
39.6
20
39.6
19.6
0
0
7//W-i2/31/97
18
39.6
20(e)
39.6
19.6
0
0
1998-present
12
39.6
20
39.6
19.6
0
0
74
Shackelford
capital losses. Table 1, colunm (2), shows the change in
marginal tax rates
when a stock shifts from short-term to long-term,
assuming the nettings
yield both net short-term capital losses and net long-term
capital losses.
Because short-term and long-term losses provide
the same deduction
under current law, the marginal tax rate change is zero
when a stock
passes from short-term to long-term
[bottom row of Table 1, column (2)1.
Note that the marginal tax rate change is zero regardless
of whether the
specific stock being evaluated has appreciated or
depreciated.
If one netting yields net capital gains and the other netting
yields net
capital losses, a single income or deduction amount is
computed from the
difference in the two initial nettings. For example, assume
long-term
capital gains are 9, long-term capital losses are 4, short-term
capital losses
are 3, and short-term capital gains are
2. The initial nettings wifi yield net
long-term capital gains of 5(9-4) and net short-term
capital losses of 1 (3-
2). A final netting produces a single net long-term
capital gain of 4 (5-1).
Here, the only gain or loss included in the
individual's taxable income is
the net long-term capital gain of 4, which is taxed at
the long-term capital
gains tax rate.
If this additional netting is required, then taxes are
unaffected by
whether a gain is long-term or short-term or whether a loss is
long-term
or short-term. To illustrate, suppose
the individual in the preceding
example delays the sale of an appreciated property until it
qualifies for a
long-term gain. The long-term capital gains increase to
10, and the short-
term capital gains fall to 1. Net long-term
capital gains are now 6 (10-4),
and net short-term capital losses are now 2 (3-1). The
final single net
long-term capital gains is unchanged at 4 (6-2).
Likewise, if the individ-
ual accelerates a sale, increasing the short-term gain
and decreasing the
long-term gain, then the total taxes are unaffected.
Shifting losses be-
tween long-term and short-term status also
does not affect the individ-
ual's tax liability.
To restate using current rates, assume (1) short-term
capital losses ex-
ceed short-term capital gains, (2) long-term capital gains
exceed long-term
capital losses, and (3) total (short- plus long-term)
capital gains exceed
total capital losses. Under these facts, an additional
dollar of long-term
capital gains increases taxes by 20 cents, because net
long-term capital
gains have risen by 1 dollar. However, an
additional dollar of short-term
capital gains also increases taxes by 20 cents. The short-term
gain reduces
the amount by which the short-term losses exceed
the short-term gains.
Since short-term losses (net of short-term gains)
offset long-term gains,
the effect of an additional dollar of short-term
capital gain is to increase net
long-term capital gains by 1 dollar and taxes by 20 cents.
Reaction to Capital Gains Tax Changes
75
Similarly, an additional dollar of long-term capital losses reduces taxes
by 20 cents, because long-term capital gains, net of long-term capital
losses, have fallen by 1 dollar. An additional dollar of short-term capital
loss also decreases taxes by 20 cents. The short-term loss increases the
amount by which the short-term losses exceed the short-term gains by 1
dollar. Since short-term losses (net of short-term gains) offset long-term
gains, the effect of an additional dollar of short-term capital gain is to
decrease net long-term capital gains by 1 dollar and reduce taxes by 20
cents.
To summarize, the marginal tax rate associated with the sale of a stock
must be evaluated with a portfolio perspective where all other gains and
losses are considered. Under current law, if the investor's portfolio of
gains and losses creates either net long-term capital losses
or net short-
term capital losses, then the marginal tax rate for a particular stock does
not change when the stock passes the one-year holding period. The prefer-
ential long-term capital gains tax rate only affects individuals whose total
long-term capital gains equal or exceed long-term capital losses and
whose total short-term capital gains equal or exceed short-term capital
losses [Table 1, colunm (1)1. These conditions hold regardless of whether
the stock being evaluated has appreciated or depreciated. The only
excep-
tion to this rule, which footnote 1 assumes is not applicable, occurs if the
gain or loss from the stock being evaluated alters the overall portfolio gain
or loss position. In this case, the marginal tax rate becomes endogenous to
the decision to sell. Such analysis is beyond the scope of this
paper.
The netting provisions introduce a timing dimension to the investor
trading decision. Generally, investors maximize returns by realizing tax-
favored long-term capital gains and deductible capital losses in different
years (Constantinides,
1984).
Separation prevents the loss of tax-favored
treatment through the netting of long-term capital gains against capital
losses. Consistent with separation, Dhaliwhal and Trezevant
(1993) find
that January returns are greater for appreciated (depreciated) stock after
a year with a bull (bear) market. Their results are consistent with inves-
tors selling appreciated (depreciated) stock during the final days of De-
cember of bull (bear) market years, segregating long-term gains and
deductible losses between years.
Finally, the total deduction for capital losses, both long-term and
short-term, is currently limited to
$3000 annually for individuals. The
limit was $2000 in 1977
and $1000 in earlier years. Excess capital losses
are carried forward indefinitely, retaining their long-term and short-
term status. Thus, the marginal tax rate for a carried-forward deduction
is reduced for the time value of money.
76
Shackelford
3. NECESSARY CONDITIONS FOR CAPITAL
GAINS
TAXES TO AFFECT STOCK PRICES
At least seven conditions must hold for stock prices to be
affected by a
change in the long-term capital gains tax rate. These
factors are equally
applicable to a change in the holding period.
3.1 Condition 1: Individual as Marginal Investor
The marginal shareholder must be an individual or a
flow-through entity
(e.g., mutual fund, partnership, S corporation, limited
liability corpora-
tion) that passes capital gains to individual tax returns.
Other investors,
such as corporations, qualified plans (e.g., pensions), tax-exempt
organi-
zations, and foreign investors, face the same tax rate
regardless of the
duration the property is held. If the marginal shareholder
is not an
individual in a tax bracket where long-term capital gains are taxed
favor-
ably, changes in the capital gains tax rates should not
affect prices.
Extant studies (e.g., Mifier and Scholes, 1982) present
evidence consis-
tent with the marginal investor not being a
taxable individual investor.
3.2 Condition 2: Net Portfolio Gain Position
The long-term capital gains tax rate must apply to the
marginal investor's
realization after applying the netting provisions discussed
above. For
example, in Table 1, column (A), when the investor's portfolio
of short-
term capital gains exceeds or equals short-term
capital losses and long-
term capital gains exceed or equal long-term
capital losses, the long-term
capital gains tax rate applies to a realization. More generally,
long-term
capital gains must exceed long-term capital losses and the excess
of short-
term capital losses over short-term capital gains,
if any. Otherwise, the
investor's marginal tax rate is unaffected by a change in the
long-term
capital gains tax rate.
An effect of the netting provisions is to relax the link between
capital
gains tax changes and the pricing of specific stocks.
Instead of the appli-
cable tax rate being determined by the stock's price and the
investor's tax
basis, it depends on the investor's portfolio of gains and losses
through-
out the year. Moreover, determination of the
portfolio position is made
annually, so the applicable tax rate is uncertain before year-end.
3.3 Condition 3: Holding Period
The marginal investor must be willing to invest for the requisite
holding
period. The advantage of long-term capital gains treatment must
domi-
nate nontax incentives to sell earlier, e.g.,
portfolio rebalancing. Al-
Reaction to Capital Gains Tax Changes 77
though many shares are held for long periods, day traders and other
individuals with short investment horizons may find the inducement of
a lower tax rate insufficient to defer their sales.
To illustrate the coordination of taxes and market risk, let P(1 - T) + BT
equal the after-tax proceeds, where P is the sales price, B is the tax basis,
and T is the long-term capital gains tax rate. A change in the long-term
capital gains tax rate (LIT) leaves the after-tax proceeds unchanged if the
price falls by LIr (P - B)/(1 - T - LiT). For example, the benefit of IRA
97's 8-percentage-point decline in the long-term capital gains would
have been fully offset by a price decline equal to 10 percent of the share's
appreciation, i.e., P - B (see footnote 4 in Guenther, 1999, for a similar
analysis).
3.4 Condition 4: Taxable Disposition
The marginal investor must intend to dispose of the stock in a taxable
transactionspecifically, secondary market trades, share repurchases,
or corporate liquidation (Lang and Shackelford, 2000). Any other invest-
ment strategy (e.g., buy-and-hold or nontaxable disposition) renders
capital gains taxes irrelevant. Although each trading day provides ample
evidence that some individuals sell securities, many stocks likely are
intended to be held until death, avoiding all income taxation on their
appreciation. Some shares are intended to remain in family hands across
generations through inter vivos gifts. Others are intended to be contrib-
uted to charities, avoiding all taxation on appreciation. Still others are
intended to be exchanged for acquirer's stock in a tax-free reorganiza-
tion. To the extent investors anticipate never selling their property in a
taxable disposition, the influence of changes in the long-term capital
gains tax rate on prices is diminished.
A nontaxable disposition method discussed at length in theoretical
finance and public economics is the use of intricate deferral strategies
(e.g., equity swaps) that enable investors to diversify without triggering
a capital gain (see, e.g., Constantinides, 1983, 1984; Stiglitz, 1983;
Scholes and Wolfson, 1992; Shackelford, 2000). Whether perfect substi-
tutability among financial assets precludes the possibility of taxes affect-
ing equity prices is an empirical question (see Poterba's 1987a analysis).
However, anecdotes in the business press (e.g., Estee Lauder's well-
publicized shorting-against-the-box) suggest that some investors at least
partially avoid capital gains taxes.
3.5 Condition 5: Compliance
The marginal investors must pay the capital gains tax generated at real-
ization. Noncompliance with the capital gains tax law would weaken
78
Shackelford
equity reactions to capital gains tax changes. Landsman, Shackelford,
and Yetman (1999) identify three reasons that capital gains noncom-
pliance may flourish. First, the transactions creating capital gains are
usually large, increasing the returns to evasion. Second, capital gains
transactions are irregular and infrequent, making it difficult for the tax-
ing authorities to establish baselines cross-temporally or across taxpay-
ers. Third, tax bases are not tracked by third-party reports, and unless
brokers are employed, no third-party reports are required to track sales
proceeds.
Unfortunately, too little is known about capital gains tax compliance
rates to assess their effect on the relation between capital gains taxes and
equity. The nearly sole source of information, Internal Revenue Service
estimates from the nine Taxpayer Compliance Measurement Program
(TCMP) surveys from 1965 to 1988, indicates that the percentage of
actual capital gains that appear on tax returns ranges from 61 percent in
1976 to 93 percent in 1988.2 This compares with 99-percent compliance
for wages and 98-percent compliance for interest in the 1988 TCMP
survey. Examining data from six TCMP surveys, Poterba
(198Th) adds
that capital gains tax compliance is decreasing in marginal tax rates.
3.6 Condition 6: Alteration of Expectations
The change in capital gains tax policy must alter the marginal investor's
expectations about the capital gains tax rate that wifi apply when the
stock is sold. Investors likely perceive that the life of any change in
capital gains tax policy is short. The taxation of capital gains and losses
has been controversial for decades, and policymakers continually ad-
vance proposals for change, including elimination. Unless selling is an-
ticipated in the immediate future, an investor likely relies little on a
change in current capital gains tax rates to forecast the relevant rate at
disposition. Thus, the impact of a change in capital gains taxes is dimin-
ishing in the individual's investment horizon.
3.7 Condition 7: Inelastic Supply
Inelasticities in the supply of capital must prevent immediate readjust-
ment throughout the economy following a change in the long-term capital
gains tax rate. For example, suppose reductions in long-term capital gains
tax rates attract individual investors. The surge of individuals wifi apply
upward price pressure and decrease equity returns to nonindividual in-
vestors. Lacking transaction costs, nonindividual investors would inune-
2
In his review of 1979 tax returns, Thompson (1987) notes that the capital gains tax
compliance rate for stocks is higher than for business property and personal residences.
diately shift from equities to investments less favorably taxed from
an
individual's perspective. The downward price pressure from nonindi-
viduals leaving the market could offset the upward price pressure from
individuals entering the market, leaving stock prices unaffected.
3.8 Summary
To summarize, all seven of the above conditions must hold for a change
in the long-term capital gains tax rate to affect prices. If any condition
does not hold, a firm's stock price will be unaffected by a change in
capital gains-tax policy, except through indirect macroeconomic shifts.
No direct link between the change and the firm's price wifi
occur. It
seems reasonable that for at least some companies, all seven conditions
wifi not hold. Thus, for at least those companies, a change in the capital
gains tax rate wifi not affect equity prices.
4. MODEL
Lang and Shackelford (2000) assume the seven conditions hold and
model the share-price effects of a change in the long-term capital gains
tax rate. Their model, reproduced below, provides a useful benchmark
for predicting the stock-price reaction to a change in the long-term rate.
They assume that the present value of a firm's future free cash flows (F
per period) and the present value of its shareholder distributions
(D1
is
the initial distribution) can be equated with a distribution growth rate
y.
F
D1(1
+
y)
n=1 (1
+
r)
n=1
(1
+
The share price at time t (Pr) equals the expected dividends at t
+
1,
after shareholder dividend taxes (T"), plus the anticipated sales price at
t
+
1 (P1), less shareholder capital gains taxes (T') on the change in
price, discounted at r:
P
=
E
+ D1
(1 - T1)
- (P+1 -
1+r
If T
=
TC and i-
T'1 for all t, current prices
P0
can be expressed as
Po
D1(1T')
Reaction to Capital Gains Tax Changes
79
r [Tc
+ (D1/F)
(1 - Tc)]
(1)
80
Shackelford
al)0
FD1
=PO
a1C (F_Di)Tc+Dl
The derivative implies that if a firm retains part of its internally gener-
ated cash flow, then a decrease in the capital gains tax rate increases its
stock prices and the rise in stock price increases with the cash retained.
To gauge the economic magnitude of the 1997 capital gains tax cut,
assume a firm is generating $25 of F, is paying $5
of D1, and has a 10-
percent discount rate. Evaluated at the maximum statutory tax rates
before the reduction, an unanticipated capital gains tax rate cut from 28
percent to 20 percent increases share prices by approximately 15 percent.
If the firm's dividend yield is one percentage point greater (less), then
prices rise by about 12 (20) percent, a 3- (5-)percentage point change in
returns. These estimates likely provide an upper bound for actual
stock
price reactions, because they assume all investors are affected by the rate
change, the rate change is fully unanticipated and immediately enacted,
dividend policies are immutable, and future distributions and taxes are
certain.
Klein (1999) shows that this model depends critically on the assump-
tion of no unrealized gains at the beginning of the investment period. If
investors have unrealized gains, a reduction in the capital gains tax rate
could actually reduce stock prices. This counterintuitive result occurs
because sellers now demand less compensation from buyers to trade.
Thus, the directional prediction associated with a change in the capital
gains tax rate depends on whether the stock's appreciation has occurred
in the past or is anticipated in the future.
Even if all seven conditions are met and the model correctly depicts
the effects of capital gains taxes on share prices, it remains an empirical
issue whether the price pressure applied by the capital gains tax policy
changes is sufficient to move stock prices. To make that assessment, four
empirical studies have recently analyzed TRA 97 and IRSRRA 98. Each
attempts to determine whether stock price movements around the
legis-
lative changes are consistent with capital gains taxes affecting equity
values. The next two sections provide a summary of each study's motiva-
tion, design, and findings.
5. TAXPAYER RELIEF ACT OF 1997
5.1 Summary of Lang and Shackelford (2000) (LS)
This study analyzes stock price reactions to the 1997 announcement that
capital gains tax rates would be reduced. Tax legislative information
(4)
Reaction to Capital Gains Tax Changes
81
usually leaks to the market over a long period as legislation slowly works
through Congress. With TRA 97, investors may have changed their
expectations about a capital gains tax rate change in a more compressed
period. On April 30, 1997, after months of uncertainty about capital
gains tax legislation, the Congressional Budget Office released an
un-
scheduled, favorable revenue estimate. The next morning, May 1, 1997,
the Wall Street Journal and the New York Times reported that the CBO
release had enabled negotiators to finalize the budget, including a capital
gains tax reduction.
The following day, May 2, 1997, the Clinton administration and
con-
gressional leaders announced general agreement on the fiscal 1998 bud-
get. Included in the accord was a commitment to an unspecified reduction
in the maximum statutory long-term capital gains tax rate for individuals,
which was eventually codified in TRA 97. The business press immediately
speculated that the capital gains tax reduction would shuffle individual
shareholdings and depress the market. For example, the Wall Street Jour-
nal (May 5, 1997) quoted an unnamed market strategist as predicting the
capital gains tax cut "would attract investor attention even more toward
stocks with a high probability of capital appreciation and away from divi-
dends" (p. C12). However, they warned that ".
.
.
, a
burst of selling may
hit the markets, strategists say. That could be the reaction, at least temp
o-
rarily, as investors with big long-term profits rush to lock in their gains"
(p. Cl).
If the CBO release and the subsequent accord substantially changed
the probability that capital gains tax rates would be cut, then the market
response to the capital gains tax rate reduction should have been concen-
trated over a few days. LS hypothesize that stock returns during that
week were negatively correlated with dividend yields because the
prom-
ise of a lower capital gains tax rate was less relevant for firms paying
(large) dividends.3 Applying a market-model approach, they investigate
the stock-price reaction of dividend-paying and non-dividend-paying
stocks during the budget-accord week. The analysis is conducted
on the
2,000 largest U.S. corporations as reported by Datastream for the 129
weeks from January 1995 through the event week (239,296 observa-
LS note the similarity the spirit of their analysis and a Wall Street Journal (April 25, 1997)
report that Brian Wesbury, chief economist at the Chicago bond firm of Griffin, Kubik,
Stephens & Thompson, characterized the Nasdaq Composite as an indicator of the
mar-
ket's expectations of the future capital gains tax rate, "a little cap-gains futures contract."
Wesbury related movements in the Nasdaq since November 1996 to changes in the proba-
bility of a capital gains tax rate reduction. The IJJIA was termed less sensitive to capital
gains tax changes because its stocks "throw off a relatively heavy share of their profits in
dividends."
82 Shackelford
tions). Of the 1,975 sample firms with complete data, 1,247 (63 percent)
pay dividends.
LS find that the mean return during the accord week was 6.1 percent
for dividend-paying stocks and 12.9 percent for the non-dividend-
paying firms. Regression analysis is undertaken to control
for possible
nontax differences in return, such as risk. The regression summary
statistics in Table 2, panel A confirm that non-dividend-paying compa-
nies outperformed dividend-paying companies during the event
week.
The regression coefficient on the variable of interest is 4.3,
indicating
that, after controlling for risk, the returns of non-dividend-paying
stocks exceeded the returns of other firms by 4.3 percentage points, on
average.
Table 2, panel B shows results for a similar regression that substitutes
TABLE 2
Regression Coefficient Estimates
(t Statistics)
Panel A
Regression equation(t'):
returns1 =
dividend + /2 week + /33 dividend X week +
/3 S&P5OO + e
/33 = 4.3
statistic = 14.5
Sample: 2,000 largest U.S. corporations as reported by Datastream for which
complete data are available
Number of firms
1975
Number of observations
239,296
Panel B
Regression equation(b):
returns =
dividendyield + /2 weeks + /33 dividendyield X week +
f34
S&P5OO1 + e
/33 = 0.29
f-statistic = 5.1
Sample: Dividend-paying stocks from the 2,000 largest U.S. corporations as re-
ported by Datastream for which complete data are available
Number of firms
1247
Number of observations
157,055
Adapted from Lang and Shackelford (2000, Tables 2, 3). Dependent variable: weekly return.
returns = firm i's weekly return for the 129 weeks from January 1995 through
the week of the
budget accord; dividend1 = a categorical variable that equals one if firm i paid a dividend within the
prior year; week = a categorical variable that equals one if the budget accord occurred in
week I;
S&P5OO, = Standard & Poor's 500 index if firm i and week I, else zero; and dividendyield1 = firm i's
dividend yield.
Reaction to Capital Gains Tax Changes
83
dividend yields for the dividend categorical variable and examines ordy
dividend-paying stocks. The regression coefficient on the dividend
yield is significantly negative, indicating that current dividend yields
are correlated with stock-price performance during the budget recon-
ciliation week. The coefficient estimate is 0.29, indicating that a
one-percentage-point decrease in the dividend yield results in a 0.29-
percentage-point larger stock price increase on the announcement of
the budget agreement.
In short, LS infer from their findings that equity price responses to the
1997 announcement of a reduction in the capital gains tax rate cut were
decreasing in dividend yields. Contrary to some predictions, however,
they find no evidence of a market slump driven by a reduction in the
compensation for capital gains taxes that selling shareholders demand
from buyers. Evaluation of returns throughout the summer of 1997 fails
to find evidence of downward price pressure from selling shareholders.
5.2 Summary of Sinai and Gyourko (1999) (SG)
SG examine the same issue as LS, but with different firms and a different
perspective. They test whether buyers compensate sellers for the capital
gains taxes generated by sales. They examine the stock returns of pur-
chasers of real estate to assess whether TRA 97 changed the compensa-
tion that buyers provide sellers.
SC conduct their study by examining equity real estate investment
trusts (REITs), publicly-traded companies that own and operate real
estate. Umbrella partnership REITs (UPREITs) are similar to other REITs,
except that sellers of real estate to UPREITS can avoid immediate capital
gains taxation if they are paid in UPREIT equity interests rather than
cash. This nontaxable option is unavailable for traditional REITs. The
distinction between traditional REITS and UPREITs is analogous to the
distinction in the market for corporate control between taxable cash
acquisitions and tax-deferred stock acquisitions.
SC hypothesize that TRA 97's capital gains tax rate reduction bene-
fited traditional REITs more than UPREITs. All individuals selling to
REITS potentially benefit from the rate reduction, while only individuals
selling to UPREITs who receive cash (i.e., do not opt to receive tax-
deferred equity interests) could benefit from the change.
To test the impact of TRA 97, SC evaluate the 1996 and 1997 daily stock
prices for 129 traditional REITs and UPREITs. They predict that UPREITs
that derive their value more from future acquisitions underperformed
compared with similar traditional REITs in 1997. Their research design
enables them to distinguish between performance in the two organiza-
tional forms, between years, and between more and less acquisitive
Number of observations = 258
Adjusted R2 = 0.07
Adapted from Sinai and Gyourko (1999, Table 8). Dependent variable: natural logarithm of the
average share price in September less the natural logarithm of the average share
price in January.
Sample: 129 companies for 1996 and 1997.
LIPREIT is 1 if firm i is an UPREIT; Y1997, is 1 if period t is 1997; acquisition is 1 if firm i's rent-to-
value ratio is below the weighted median for the sample.
firms. Table 3 reports the results from estimating the regression. As
predicted, the regression results are consistent with TRA 97's capital
gains tax rate reduction being more beneficial to traditional REITs than to
UPREITs, conditional on the company's appetite for acquisitions.
A major distinction between SC's and LS's analyses of IRA 97 is the
event period. Unlike LS, who find evidence that prices for
the largest
U.S. companies responded to the capital gains tax cut within one week,
SG are unable to detect a response using a short window. Only when
they investigate long event periods, e.g., January 1997 to September
1997, do they find evidence that the cut affected REIT prices. As the
event period widens, the probability increases that it includes more
of
the period during which information moved prices. However, the proba-
bility also increases that the analysis is contaminated by other factors
that differentially affect traditional REITs and UPREITs.
An explanation for this difference in the studies is that LS's setting
provides more power. In their primary test, LS examine 239,296 firm
week price changes, while SG are limited to 258 firmyear price changes.
In addition, LS examine the largest, more widely traded, presumably
more efficiently priced U.S. equities, while SG evaluate an
unusual orga-
nizational form in a single sector of the economy. Nonetheless, regard-
less of the event period, both studies find evidence that TRA 97's capital
gains tax rate reduction impacted share prices in a predictable direction.
84
Shackelford
TABLE 3
Regression-Coefficient Estimates and Standard Errors(a)
Explanatory
Coefficient
Standard
variab1e11'
estimate
error
Y1997
0.017
0.042
UPREIT
0.067
0.037
acquisition
0.023
0.039
Y1997 x LIPREIT
0.016
0.053
Y1997 X acquisition
0.047
0.055
UPREIT X acquisition
0.009
0.052
Y1997 X UPREIT X acquisition
0.146
0.073
Reaction to Capital Gains Tax Changes
85
5.3 Summary of Guenther (1999)
The May 2, 1997 announcement that the President and the Congress had
agreed to reduce the capital gains tax rate did not state
an effective date
for the rate change. The business press reported that individual inves-
tors withdrew from the market to await an effective date. For example,
the Wall Street Journal (May 5, 1997) reported ".
.
. a very noticeable
seller's strike." It quoted David Shulman, chief equity strategist at Salo-
mon Brothers in New York, stating, "'I would suspect that as long as
the effective date is in limbo, we would see delays in selling.' The worst
thing Washington can do is 'to let this thing drag on' without details.
'Then you create economic uncertainty, and you can get a bubble
on the
way up. You could stop a whole series of business transactions right
now in their tracks.' " The New York Times added that the reduction
should ". .
. in
the short term, keep investors from selling until they
know what the effective date of the tax cut wifi be." In
response to
purported market paralysis, Senate Finance Chairman Wiffiam Roth and
House Ways and Mean Chairman William Archer jointly announced
May 7, 1997 that the effective date for any capital gains tax cut would be
that day.
Guenther (1999) investigates whether shareholders delayed selling ap-
preciated stock in anticipation of the 1997 reduction in the capital gains
tax rate. He hypothesizes that if individuals withdrew from the market
following the CBO announcement on April 30, 1997, and reentered fol-
lowing the May 7 announcement, then ex-dividend day returns for the
week preceding the May 7, 1997 announcement should have been less
than usual.
Extant studies (e.g., Elton and Gruber, 1970) document that ex-
dividend days are marked by positive stock returns. This is consistent
with individuals selling appreciated shares before the ex-dividend date
at the favorable long-term capital gains tax rate, avoiding tax-disfavored
dividends, and sharing their tax savings (the difference between the
long-term capital gains rate and the ordinary tax rate) with other inves-
tors through upward price adjustments. However, if individuals await
the new reduced rate and withdraw from the market, then no tax
sav-
ings are available to share with remaining investors, eliminating the
typical upward price pressure characterized by ex-dividend day returns.
To test this proposition, Guenther compares ex-dividend-day excess
returns for the week ending May 7, 1997 (the day of the announcement
of the effective date) with ex-dividend-day returns for the rest of 1997.
Analyzing dividend-paying companies only, a pooled, cross-sectional,
time-series model regresses excess returns on a categorical variable for
86
Shackelford
Number of observations = 3785
F statistic = 2.923 (p < 0.0076)
Adjusted R2 = 0.003
TABLE 4
Regression Summary Statistics(a)
(a) Adapted from Guenther (1999, Table 5). The dependent variable is firm j's
daily return on ex-
dividend day t less the average of the daily returns on day t for all sample firms except firms going ex-
dividend within three days before or one day after day t; week is 1 if observation is an
ex-dividend day
from May 1, 1997 through May 7, 1997; time1 is 1 if observation is an ex-dividend day t
from May 8,
1997 through July 27, 1997; time2 is 1 if observation is an ex-dividend day t from July 28, 1997
through
December 31, 1997; loss is 1 if the cumulative return for firm) from April 1, 1996 through
April 1, 1997
is negative; discrete is the difference between the dividend amount and the closest
discrete tick price
that is less than or equal to the dividend, divided by the ex-dividend-day-t stock price; yieId1 is
firm )'s
dividend amount divided by the ex-dividend-day-t stock price.
the week and control variables. The analysis is conducted for 3,785 ex-
dividend days spanning 983 firms.
Table 4 shows the regression coefficient estimate for the week's indica-
tor variable is 0.41 percent (t statistic of 2.11),
indicating excess ex-
dividend-day returns for the week ending May 7, 1997 are significantly
lower than those for other periods. This finding is consistent
with a
withdrawal of individual investors facing long-term capital gains rates
during the week of uncertainty about the effective date.
6. INTERNAL REVENUE SERVICE
RESTRUCTURING
AND REFORM ACT OF 1998
6.1 Summary of Blouin, Raedy, and Shackelford
(1999b) (BRS)
The Internal Revenue Service Restructuring and Reform Act
of 1998 re-
pealed TRA 97's extension of the holding period, reducing the
long-term
capital gains holding period from 18 months to 12 months, effective retro-
active to the beginning of 1998. The business press
reported that the
holding period reduction caused share prices to slump. For
example, the
Wall Street Journal (August 26, 1998, p. Al) linked the 1998
third-quarter
Explanatory
variable
Coefficient
estimate
Standard
error
t statistic
Two-tailed
p value
intercept
0.0007
0.0007
0.95
0.342
week
0.0041
0.0019
2.11
0.035
timeTl
0.0007
0.0008
0.95
0.340
time2
0.0004
0.0006
0.60
0.552
loss
0.0015
0.0006
2.38
0.018
discrete
0.3452
0.1647
2.10
0.036
yield
0.1083
0.0793
1.37
0.172
Reaction to Capital Gains Tax Changes
87
stock market decline to selling pressure created by the reduction in the
holding period. Marshall Front of Trees Front Associates observed "a
much greater willingness" to sell among clients whose investments quali-
fied for long-term capital gains under a 12-month holding period, but
not
under an 18-month period. Terry Banet, a vice president and portfolio
manager at J.P. Morgan, cited the reduction in the holding period as
"accelerat[ing] the sale of many of the positions" in stocks that qualified
for long-term capital gains under the reduced holding period.
BRS test whether sell-offs, such as those implied by the Wall Street
Journal, can be detected using conventional capital markets event study
methodology. To maximize the power of their tests, BRS focus
on the
returns of initial public offerings. IPOs offer three advantages: (1) indi-
vidual holdings are disproportionately large for IPOs, (2) the beginning
of the holding period for shareholders who bought at the fF0 is observ-
able, and (3) the tax basis for those shareholders is measurable (Reese,
1998). To concentrate on IPOs for which the long-term capital gains
tax
policy is most relevant, BLS limit the analysis to IPOs that have appreci-
ated since listing.
BRS's treatment group are IPOs whose initial public shareholders
met
the 12-month period, but not the 18-month period. The control
group
includes those same IPOs outside the event period and other IPOs
whose listing occurred from 6 to 12 months earlier and from 18
to 24
months earlier. The sample includes 823 IPOs from 1996, 1997, and 1998.
Specifying precisely the period during which the market received infor-
mation about the reduction in the holding period is difficult. Neither the
House of Representatives' nor the Senate's original bill contained
any
capital gains provisions. On June 24, 1998, the conference committee,
following closed sessions, produced the first bifi eliminating the 18-
month holding period.
However, information potentially leaked to the market at least three
times before the conference committee released its report. First, acting
seemingly independently of the tax-bill deliberations, the House Budget
Committee on June 5, 1998 issued its budget resolution for the fiscal
year
beginning October 1, 1998. The resolution assumed elimination of the
18-month holding period. Second, ten days later, on June 15, 1998,
Senate Majority Leader Trent Lott expressed disappointment that the
tax
bifi (then under consideration in the closed conference committee) did
not eliminate the 18-month holding period for long-term capital gains.
Third, the following day, House Speaker Newt Gingrich predicted that
in September 1998 the tax committees would construct
a bifi eliminating
the 18-month holding period. Because the event period cannot be speci-
fied precisely, BRS report the results for multiple event periods.
88
Shackelford
To test the effects of the holding-period reduction,
BRS regress daily
stock returns on categorical variables that indicate whether the IPO's
initial shareholders were affected by the change and that indicate the days
included in the event period. The key variable is an interaction of the two
indicator variables. The coefficient on the interaction indicates the mean
daily percentage difference in returns between the treatment and control
IPOs. BRS interpret a negative coefficient on the interaction as
evidence
that the treatment IPOs underperformed during the event
period.
Table 5 presents results using various event periods. The coefficient
on the interaction is most
significantly different from zero (0.05 level
TABLE 5
Regression Summary Statistics1
Regression model("): returns1 = I3o + J3 midJPO1 (1 + info) +
"Significant at the 5-percent level, one-tailed test.
'Significant at the LU-percent level, one-tailed test.
Adapted from Blouhi, Raedy, and Shackelford (1999b, Table
regressions.
Sample: 61,968 daily returns from 1996, 1997, and 1998 Initial
daily stock return for day t; inidJPO = categorical variable that
more than year, but no more than 18 months, before day t; info =
If day t is during the event period.
4. Adjusted R2 is 9 percent for all
public offerings. ret urns, = firm i's
equals one if firm i's IPO occurred
categorical variable than equals one
Test Period
Variables
midJPO
midJPO X info
Coefficient
statistic
Coefficient
()
statistic
Maximum t statistic
6/17-6/24
0.018
0.49
_0.292**
-1.71
Full period
6/5-7/
0.002
0.04
0.010
0.13
3 days beginning with
budget report
6/5-6/9
0.014
0.37
-0.202
-1.19
Budget to conference
6/5-6/24
0.021
0.54
_0.149*
-1.30
Lott comment to
conference
6/14-6/24
0.017
0.45
_0.198*
-1.33
AP report and
conference bifi
6/23-6/24
0.007
0.19
-0.166
-0.57
Conference report
6/24
0.008
0.21
-0.433
-1.05
Postconference
6/25-7/8
-0.009
-0.23
0.147
1.15
Reaction to Capital Gains Tax Changes
89
using a one-tailed test) for the period June 17, 1998 (the day following
Speaker Gingrich's prediction) to June 24, 1998 (the day the conference
committee released its bifi and one day after press reports that the hold-
ing period would revert to 12 months). The estimate implies that
over
the six days, IPOs with initial public shareholders affected by the hold-
ing period underperformed by a mean daily return of 0.29 percent.
No other subperiods find significance at conventional levels. No evi-
dence is produced consistent with the Wall Street Journal anecdote that
prices were falling in the third quarter in response to the holding period
change. The findings suggest that whatever price response occurred had
been completed by the beginning of the third quarter.
7. INFERENCES FROM TRA 97 AND
IRSRRA 98 STUDIES
As discussed above, the conditions under which TRA 97 and IRSRRA 98
modified capital gains tax policy provide unusually powerful settings for
estimating relations between share prices and capital gains taxes. The
four studies summarized above likely represent the first of many analy-
ses of the 1997 and 1998 legislation that wifi advance our understanding
of the effects of capital gains tax changes on stock prices. Together these
studies provide at least four initial inferences that may be useful as
Congress continues to revisit the appropriateness and level of capital
gains taxation.
One, capital gains tax changes affect stock prices. Although each
study analyzes a different sector of the stock market, all present evi-
dence that share prices responded to the 1997 and 1998 legislation. The
findings imply that the seven necessary conditions for capital gains taxes
to affect share prices, outlined above, held during enactment of TRA 97
and IRSRRA 98. This suggests that, at least during these tax changes,
individuals were the marginal shareholders for some firms.
Two, the stock market responds quickly to information about tax legis-
lation. Notwithstanding SG's inability to detect a response using a short
window (which is likely attributed to insufficient power), LS and BRS
show that the price response is completed within days. These studies
find no evidence of continuing tax effects, such as suggested by the Wall
Street Journal's link between the 1998 legislation and stock market
reac-
tions weeks later.
Three, much of the market reaction has been completed when changes
are publicly announced. For example, LS find prices moving before the
May 2, 1997 budget accord, and BRS find share-price adjustments had
completed their shift by the release of the conference committee's report.
90
Shackelford
Price movement preceding public release of information is consistent with
the adage that Wall Street "buys on the rumor and sells on the news."
Investors trading initially on the "news" (e.g., budget accord announce-
ment or the committee conference's release) would have missed much
of
the price reaction.
Four, the estimated stock-price responses to capital gains tax changes
are of economic significance. Consider the
annualized returns from the
estimates in these studies. LS's estimates suggest that during the accord
week, non-dividend-paying stocks outperformed other stocks by 350
percent using raw returns or 225 percent using risk-adjusted regression
estimates. Guenther's estimates show that excess returns on ex-divi-
dend days are normally 100 percent greater on an annual basis than
those experienced around the rate change. BRS's estimates imply the
holding-period change depressed the share prices of IPOs with affected
initial public shareholders by 75 percent on an annual basis. SG's re-
sults do not permit the same annualized translation; however, their
estimates imply that the capital gains rate reduction was borne fully by
acquisitive UPREITs.
Compare these estimates with the American Council for Capital For-
mation (ACCF)'s widely reported testimony to the House Ways and
Means Committee on June 23, 1999. Citing Wyss (1999), the ACCF stated
that the 1997 rate reduction accounted for one-quarter of the market's
subsequent 30-percent appreciation. During the week of the budget ac-
cord alone, LS find non-dividend-paying stocks outperformed dividend-
paying firms by nearly 7 percent. Thus, LS report an incremental boost
to non-dividend-paying stocks in one week that was almost as large as
the two-year increase that the ACCF trumpeted as evidence that the
stock market benefited from the 1997 rate reduction.
8. CLOSING REMARKS
In summary, the Taxpayer Relief Act of 1997 and the Internal Revenue
Service Restructuring and Reform Act of 1998 provide a useful setting for
reevaluating the effect of capital gains taxation on equity prices. Besides
their being the first change in capital gains tax policy in over a decade, the
market appears to have impounded information from both bills quickly,
enabling recalibration of the effect of capital gains taxes on share prices.
In general, the evidence in the initial studies of the 1997 and 1998
legislation suggests that the incentives provided by favorable long-term
capital gains taxation affect stock prices. Despite at least seven different
conditions that must hold for capital gains tax policy to affect share values,
the findings consistently show that stock prices capitalize capital gains
Reaction to Capital Gains Tax Changes
91
taxes. The stock market response to capital gains tax changes appears
rapid, complete by public announcement of the change, and material.
The results in these studies should interest tax and valuation scholars
and be useful to policymakers as they revise capital gains tax policy.
They contribute to a emerging literatureempirical (e.g., Guenther and
Willenborg, 1999; Blouin, Raedy, and Shackelford, 1999a; Poterba and
Weinsbrenner, 1998; Reese, 1998; Erickson, 1998; Landsman and Shackel-
ford, 1995; Amoako-Adu et al., 1992; Hayn, 1989) and theoretical (e.g.,
Klein, 1999; Collins and Kemsley, 1999; Shackelford and Verrecchia,
1999; Balcer and Judd, 1987)linking stock market reactions to capital
gains tax policy. The findings provide additional evidence that in at least
some situations the marginal investor is an individual whose marginal
tax rate changes when stocks cross from short-term to long-term classifi-
cation. He invests shares for the requisite holding period, intends to sell
in a taxable disposition, and complies with the capital gains tax law. His
expectation of the applicable tax rate when he sells in the future is
altered by the capital gains tax change, and supply inelasticities appar-
ently prevent immediate economic readjustment. Together these papers
raise doubts about prior assumptions that capital gains tax policy is of
little relevance for equity price formation.
REFERENCES
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