Capital Gains Taxes and Asset Prices: Capitalization or Lock-in?
University of Texas at Dallas
University of North Carolina
Douglas A. Shackelford
University of North Carolina and NBER
Harold H. Zhang
University of Texas at Dallas
First version: September 2005
Last revised: February 16, 2006
We thank Ashiq Ali, Robert Kieschnick, Suresh Radhakrishnan, and seminar participants at the University of Texas at Dallas for helpful comments. Zhonglan Dai is at the School of Management, University of Texas at Dallas, Richardson, TX 75083, firstname.lastname@example.org, Edward Maydew is at the Kenan-Flagler Business School, University of North Carolina, Chapel Hill, NC 27514, Edward_Maydew@unc.edu, Douglas A. Shackelford is at the Kenan-Flagler Business School, University of North Carolina, Chapel Hill, NC 27514, Douglas_Shackelford@kenan-flagler.unc.edu, Harold H. Zhang is at the School of Management, University of Texas at Dallas, Richardson, TX 75083, email@example.com. All errors are our own.
Capital Gains Taxes and Asset Prices: Capitalization
This paper examines the impact on asset prices from a reduction in the long-term capital gains tax rate using an equilibrium approach that considers both buyers’ and sellers’ responses. We demonstrate that the equilibrium impact of capital gains taxes reflects both the capitalization effect (i.e., capital gains taxes decrease demand) and the lock-in effect (i.e., capital gains taxes decrease supply). Depending on time periods and stock characteristics, either effect may dominate. Using the Taxpayer Relief Act of 1997 as our event, we find evidence supporting a dominant capitalization effect in the week following news that sharply increased the probability of a reduction in the capital gains tax rate and a dominant lock-in effect in the week after the rate reduction became effective. Non-dividend paying stocks (whose shareholders only face capital gains taxes) experience higher average returns during the week the capitalization effect dominates and stocks with large embedded capital gains and high individual ownership exhibit lower average returns during the week the lock-in effect dominates. We also find that the tax cut increases the trading volume in non-dividend paying stocks during the dominant capitalization week and in stocks with large embedded capital gains and high individual ownership during the dominant lock-in week.
Capital Gains Taxes and Asset Prices: Capitalization or Lock-in?
This paper jointly models and tests two effects of capital gains taxation on equity trading: a demand-side capitalization effect and a supply-side lock-in effect. Previous studies have separately identified and tested these effects, but, to our knowledge, this is the first study to evaluate them jointly and empirically document the relative dominance of each effect surrounding an event of a tax rate change. Employing an equilibrium approach, we show that in general their net tax effect on asset prices is ambiguous. Evaluating returns and trading volume around the 1997 reduction in the capital gains tax rate, we find evidence of the capitalization and the lock-in effects jointly affecting trading. In particular, the capitalization effect dominates the lock-in effect in the week following news that sharply increased the probability of a reduction in the capital gains tax rate, as buyers respond to information that future capital gains tax rates will be lower. The lock-in effect, on the other hand, dominates the capitalization effect after the rate reduction became effective.
Taxation is one of the most prevalent market frictions in financial markets. It affects investors’ decisions and distorts the valuation of assets. Capital gains taxes, in particular, play an important role in determining an investor’s trading strategies and ultimately influencing asset prices. Because investors endogenously respond to the imposition of capital gains taxes, the tax effect on asset prices can be complicated and difficult to measure. In his review of taxes in the finance literature, Graham (2003) concludes that “Though intriguing in theory, the profession has made only modest progress in documenting whether investor taxes affect asset prices…we need more evidence about the importance of personal taxes affecting asset prices…” To date, research on the effects of investor level capital gains taxes on asset prices has produced conflicting results. Several studies report that the presence of capital gains tax reduces stock price and current stock return (see Guenther and Willenborg (1999), Lang and Shackelford (2000), Ayers, Lefanowicz, and Robinson, (2003), among others), while other studies document that imposing capital gains tax increases stock price and current stock return (see Feldstein, Slemrod, and Yitzhaki, (1980), Landsman and Shackelford (1995), Reese (1998), Poterba and Weisbenner (2001), Klein (2001), Blouin, Raedy, and Shackelford (2003), Jin (2005), among others). The former is referred to as the capitalization effect of taxes and is often justified by the argument that investors would demand a lower price to buy the assets if they have to pay capital gains taxes in the future. The latter is referred to as the lock-in effect and is attributed to investors requiring higher prices to sell assets if they have to pay taxes on selling them. Recognizing that the two effects work in opposite directions, the purpose of this paper is to understand the interaction of the two effects and the circumstances under which one effect dominates the other surrounding a tax rate change.
Theoretical studies on taxes and asset pricing have been scarce and often focus on trading strategies for investors to avoid paying capital gains taxes and their impact on asset prices when investors face embedded capital gains on their asset holdings. For example, Constantinides (1983) shows that investors can rebalance their portfolios without triggering capital gains taxes if they are allowed to sell short assets in which they have embedded gains. This allows investors to separate their optimal liquidation of assets from their optimal consumption and investment policies. Klein (1999) introduces a general equilibrium model of asset pricing with capital gains taxes when investors face short sale constraints so that they cannot rebalance their portfolio without triggering capital gains taxes liability. He makes predictions on the effects on asset prices of capital gains taxes without explicitly solving for the equilibrium price. Shackelford and Verrecchia (2002) develop a trading model where the long-term and short-term capital gains tax rates differential creates a trade-off between optimal risk-sharing and optimal tax-related trading strategy. They show that sellers are reluctant to sell appreciated assets sooner because they are subject to higher capital gains taxes. To entice sellers, buyers must provide compensation in the form of higher sales prices.
In this paper, we develop a simple equilibrium model of stock markets to analyze the effects of capital gains tax on prices that jointly considers the capitalization effect and the lock-in effect. Intuitively, the capitalization argument approaches the tax effect from buyers’ perspective (demand side), while the lock-in effect views the tax impact from sellers’ perspective (supply side). A more complete analysis of the capital gains tax effects must simultaneously allow for demand and supply to interact. In equilibrium, the net effect on stock markets of the capital gains tax will be the combination of both effects. Our study provides such a unified framework and offers predictions for the capital gains tax effect on security markets.
Our model suggests that a change in capital gains tax influences asset prices by shifting both the demand for assets and the supply of assets. Specifically, when the capital gains tax is increased, the demand curve for assets is shifted down, reflecting the decline in prices required to attract buyers. An increase in the capital gains tax also shifts the supply curve up, reflecting the boost in prices required to entice current owners to sell. The equilibrium net tax effect on asset prices is ambiguous, depending on which effect dominates. An increase in capital gains taxes unambiguously reduces the float of assets (number of shares actively traded). In the event of a capital gains tax cut, the demand curve for the assets shifts up and the supply curve shifts down. The equilibrium net tax effect on asset price is still ambiguous, but the float of assets is unambiguously increased.
To detail the predictions of our model, suppose the capital gains tax rate is reduced. If the capitalization effect dominates the lock-in effect, stock prices will increase leading to higher current stock returns. Furthermore, the future returns to growth stocks (i.e., stock whose valuation depends largely on future dividend growth) are more likely to face capital gains taxes than the future returns to income stocks (i.e., those stocks currently distributing dividends). Consequently, when the capital gains tax rate is cut, growth stocks should experience even higher returns than income stocks.
Conversely, if the lock-in effect dominates the capitalization effect, we predict that stock prices will decrease and lower current stock returns. These reactions will be particularly pronounced for stocks with large price appreciation in the past. With these firms, the lock-in effect will dominate, leading to lower current returns.
Although the capitalization effect and the lock-in effect co-exist at all times, the relative importance of the two effects should vary around the timing of a capital gains tax rate change. Specifically, if there is a capital gains tax cut, the capitalization effect (price increase caused by demand shift upward) will be stronger than the lock-in effect before the tax cut becomes effective and the lock-in effect (price decrease caused by supply shift downward) will dominate the capitalization effect after the tax rate cut effective date. The reason for the timing difference is that investors react to changes in the probability of a capital gains tax rate cut before the rates actually fall. In other words, buyers could purchase stocks in response to the news of future tax cut before the stock prices fully incorporate the new lower rate. Conversely, because capital gains are taxed upon realization, current stockholders likely will not sell shares with embedded gains until the capital gains tax rate cut becomes effective. Consequently, we select different event windows for a dominant capitalization effect and a dominant lock-in effect in our empirical investigation. Different event windows are critical for identifying the relative dominance of capitalization and lock-in. We perform the empirical tests of the model predictions by examining return and volume responses to the 1997 capital gains tax cut on stocks included in the CRSP dataset for the periods between January 1, 1995 and December 31, 1997. Our empirical analysis confirms that while both the capitalization and the lock-in effects jointly influence asset prices, the magnitude of each effect differs across the timing of the tax cut and stocks with different characteristics.
The 1997 capital gains tax rate reduction provides a rare opportunity to jointly investigate the effects of capitalization and lock-in on asset prices. In late April, 1997, information leaked that the Democratic White House and the Republican Congressional leadership had reached an accord to reduce the capital gains tax rate. This news preceded the actual effective tax rate by about one week. During that interim week, we find that the capitalization effect dominated the lock-in effect. This is consistent with individuals (the only shareholders benefiting from reduced rates) buying shares on the increased probability of lower capital gains tax rates when they sell the shares in the future. Conversely, we find that the lock-in effect dominated the capitalization effect during the week following the effective date of the tax cut. This is consistent with individual investors (i.e., again, the only shareholders benefiting from the lower rates) selling stocks with large embedded gains after the tax cut became effective.
Although consistent with the model, broad market movements surrounding the effective date may reflect other factors moving the markets during those two weeks. Our cross-sectional analyses, however, do provide compelling evidence about the effects of capitalization and lock-in. Specifically, we find that:
Non-dividend paying stocks experienced a stronger capitalization effect than dividend-paying stocks during the week the capitalization effect dominated.
Stocks with large price appreciation in the past and high individual percentage ownership experienced stronger lock-in effect and earned lower immediate returns during the week the lock-in effect dominated.
Trading volume was higher for non-dividend paying stocks during the week the capitalization effect dominated and for stocks with large embedded capital gains and high percentage of individual ownership during the week the lock-in effect dominates.
Since constructing alternative explanations for these cross-sectional findings is difficult, we infer from these results that capitalization and lock-in effects jointly affect market returns in the predicted manner.
The paper is organized as follows. Section 2 describes the model and discusses its empirical implications. Section 3 lays out the empirical methodology and section 4 provides empirical analysis and discussions. Finally, section 5 concludes.
II. The model and its empirical implications
Investors in the economy trade multiple stocks indexed by i. To facilitate our exposition, we introduce the following notations. Let be the time t market price of stock i, be the dividend distributed in period t on stock i, be the time t tax basis of the marginal investor who currently owns stock i, be the capital gains tax rate, and be the dividend tax rate. To facilitate our discussion, we denote as the price willing to pay for a share of stock i by buyers at time t and as the price willing to accept for a share of stock i by sellers at time t.
The price a typical tax sensitive marginal investor is willing to pay is determined by the expected payoff as follows:
where is the discount rate applied to the cash flow of stock i and represents the investors’ anticipated capital gain realization. We assume that the anticipated capital gain realization takes the following form:
where . This specification takes into account that investors who purchase the shares have to pay the market price, which serves as the basis for computing buyers’ capital gains taxes when they sell in the following period.1 Moreover, parameter is used to allow investors to use tax efficient trading strategies to reduce their realized capital gains.2
On the other hand, a typical tax sensitive marginal shareholder with embedded capital gains, who contemplates selling, will require a price high enough to compensate him for his tax liability. This implies:
where represents the seller’s net-of-tax reservation value for a share of stock i and is the seller’s capital gains tax. We assume that the seller’s net-of-tax reservation value is less than the market price because the tax burden is borne by both sellers and buyers in equilibrium.3
In equilibrium, the demand for the company shares equals the supply of the shares, and the price paid by the buyer equals the price received by the seller (including taxes), i.e.,
Substituting (2) into (1) and using the market clearing condition (4), we arrive at the following equilibrium price for stock i in the presence of taxes
Rewriting equation (5) recursively, we obtain the price of stock i at time t as follows:
Assuming that the dividend grows at a constant rate and the tax basis grows at rate, we have the following simplified expression for the price of stock i at time t:
Denote the first term in equation (7) as “Xi” and the second term as “Yi”. Taking the first derivative of “Xi” and “Yi” with respect to, respectively, yields:
Equation (8) is unambiguously negative and we call this capitalization effect of the capital gains tax because the term X includes dividend and dividend growth which concern a potential buyer. Furthermore, the cross derivative of with respect to dividend growth ,, is also negative. Hence, the magnitude of the capitalization effect becomes larger as the dividend growth rate of a company () increases and the dividend tax rate () decreases. This implies that in the event of a tax cut growth stocks will experience larger price increase than income stocks.
The sign of Equation (9) depends upon the size of the investors’ embedded capital gains over time. We have a positive lock-in effect if the following condition holds:
The above inequality suggests that the lock-in effect depends positively on stock i’s discount (or capitalization) rate and the marginal investor’s net-of-tax reservation price but is inversely related to the rate at which investors’ tax basis grows. If we interpret the capitalization rate as the average appreciation rate of the stock price, then the left-hand-side measures the size of embedded capital gains. If the appreciation rate is high and the marginal investor demands a high reservation price relative to the tax basis growth rate, the embedded capital gains are large and inequality (10) will be satisfied. In this case, there is a positive lock-in effect. On the other hand, if the appreciation rate is low and the marginal investors demand a very low reservation price relative to the tax basis growth rate, the investors will have little embedded capital gain or even a capital loss and there will be no lock-in effect. To empirically identify a dominant lock-in effect, we need to focus on stocks with large embedded capital gains for tax-sensitive investors.
The combined effect of capital gains tax on stock price is given by
Overall, because the capitalization effect () and the lock-in effect () work in opposite direction, the net effect of capital gains tax on stock price is ambiguous. If the capitalization effect dominates, the net effect of capital gains tax on stock price will be negative; if the lock-in effect dominates, the net effect of capital gains tax is positive.
Figure 1 illustrates the interaction between the two opposing forces. At first, suppose that there are no capital gains taxes. The demand and the supply for any particular stock are depicted as D and S in the graph and the intersection determines the equilibrium price and float of shares. Now, we introduce capital gains taxes. The demand curve shifts to the left from D to D’ due to the capitalization effect. At the same time the supply curve also shifts to the left from S to S’ due to the lock-in effect. In equilibrium, the new demand and supply curves interact with each other at new equilibrium price and new float of shares. It is obvious that new price could be higher or lower depending upon which effect dominates. However, float of shares is clearly decreased. In the event of a capital gains tax cut, the shift in demand and supply is reversed. Consequently, the float of shares is unambiguously increased. However, the change in equilibrium price remains ambiguous depending on which effect dominates: the capitalization or the lock-in.
Our analysis above has the following empirical implications. First, when the capitalization effect dominates the lock-in effect, a reduction in the capital gains tax will cause an increase in the stock price leading to higher stock returns. This will arise when potential buyers are more responsive to an imminent capital gains tax cut than are current shareholders. Conversely, when the lock-in effect dominates the capitalization effect, a reduction in the capital gain tax rate will cause a decrease in the stock price leading to lower stock returns. This will happen if current shareholders are more responsive to the capital gains tax cut than are potential buyers. Second, the float of shares is inversely related to the capital gains taxes. When the capital gains tax is reduced, both the capitalization and the lock-in effects reinforce each other to increase the number of shares actively traded. The above implications apply to all stocks with embedded capital gains and thus represent market wide reactions to capital gains tax rate change.
Our theoretical analysis also suggests that growth stocks will experience a greater price increase and higher returns than other stocks in the event of a capital gains tax cut. In general, dividend-paying stocks are more likely to be income stocks while non-dividend paying stocks are more likely to be growth stocks. This means that for the capitalization effect the stock returns are predicted to be higher for non-dividend paying firms than dividend paying firms. Further, for stocks with high percentage of tax sensitive individual ownership, the lock-in effect is stronger for larger embedded capital gains because condition (10) is more easily satisfied when the tax basis growth rate is lower relative to stock price appreciation rate. This implies that in the event of a capital gains tax cut, these stocks will experience a larger price decline than will other stocks. These implications pertain to individual stock characteristics. We thus call them cross-sectional effects of a capital gains tax rate change. In the next section, we empirically test both the market wide and cross-sectional effects of a capital gains tax change by jointly considering the capitalization and the lock-in effects.