Capital Gains Taxes and Asset Prices: Capitalization or Lock-in?
Zhonglan Dai, Edward Maydew, Douglas A. Shackelford, and Harold H. Zhang*
This paper demonstrates 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.
JEL classification: G12, H20.
Keywords: capital gains taxes, lock-in effect, stock returns
*Zhonglan Dai is at the School of Management, University of Texas at Dallas, Edward Maydew is at the Kenan-Flagler Business School, University of North Carolina, Douglas A. Shackelford is at the Kenan-Flagler Business School, University of North Carolina and NBER, Harold H. Zhang is at the School of Management, University of Texas at Dallas. We thank Ashiq Ali, Robert Kieschnick, Suresh Radhakrishnan, Scott Weisbenner, Yexiao Xu, Rob Stambaugh (the editor), an anonymous referee, and seminar participants at the 2006 NBER Behavioral Response to Taxation/Public Economics Program Meeting, the 2006 UNC Tax Symposium, and the University of Texas at Dallas for helpful comments. All errors are our own.
This paper jointly 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 tested these effects separately, 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 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 an increase in 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 actually 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 can affect 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 (2006), Ellis, Li, and Robinson (2006), George and Hwang (2006) 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. They 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-investment policies. Klein (1999) introduces a general equilibrium model of asset pricing with capital gains taxes where investors face short sale constraints so that they cannot rebalance their portfolio without triggering capital gains taxes liability. He makes predictions about the effects of capital gains taxes on asset prices without explicitly solving for the equilibrium price.
Viard (2000) analyzes the dynamic asset pricing effects and incidence of realization-based capital gains taxes. Under the assumption of small realization taxes, he derives the first-order conditions for equilibrium asset prices. To obtain the first-order effects, he linearizes the first-order conditions around the no-tax equilibrium. He finds that asset prices are increased by the current realization tax, to partly offset the sale disincentive associated with the tax, consistent with the lock-in effect. 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 analyze the effects of capital gains taxation on prices, while jointly considering 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 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 analysis suggests that a change in capital gains taxes 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 analysis, 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. Conversely, if the lock-in effect dominates the capitalization effect, we predict that stock prices will decrease and lower current stock returns. These effects are likely to apply to all stocks traded on the stock market and constitute the market wide capital gains tax effect on stock prices.
Furthermore, the capital gains tax effect will vary depending upon the characteristics of stocks because of their differences in tax costs. For instance, growth stocks (i.e., stock whose valuation depends largely on future dividend growth) are more likely to face capital gains taxes than income stocks (i.e., those stocks currently distributing dividends). Consequently, in the event of a capital gains tax cut, growth stocks should experience even higher returns than income stocks when the capitalization effect dominates the lock-in effect. For stocks with large price appreciation and a high percentage of tax sensitive investor ownership (such as individual investors and mutual funds), a capital gains tax cut will reduce investors’ tax cost of selling these stocks for portfolio rebalancing, when the lock-in effect dominates, leading to even lower current returns on these stocks. These constitute the cross-sectional effect of a capital gains tax change on asset prices.
Although the capitalization effect and the lock-in effect co-exist, the relative importance of the two effects should vary around the timing of a capital gains tax rate change. Specifically, in the event of 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 increase their demand for stocks in response to the news of future tax cut. Conversely, because capital gains are taxed upon realization, tax sensitive stockholders likely will refrain from selling 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 these 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 investors buying more shares (through both personal accounts and mutual funds) as the probability of lower capital gains tax rates when they sell in the future increased. 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 the tax sensitive individual investors selling stocks (through both personal accounts and mutual funds) with large embedded gains after the tax cut became effective.
Although consistent with our prediction, 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 greater during the week immediately before and after the tax cut becomes effective.
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 I discusses the effect of capital gains taxes on stock prices and its empirical implications using a simple demand and supply framework. Section II lays out the empirical methodology and section III provides empirical analysis and discussions. Finally, section IV concludes.
I. Capital gains taxes and asset prices in an equilibrium framework
Consider an economy in which tax sensitive investors are required to pay taxes on appreciation in stock value upon selling. The overall tax effect on stock prices will be affected by both stock buyers and sellers. In the presence of the capital gains taxes, stock buyers will require a lower price to acquire the stock to compensate them for their future tax liability (the capitalization effect). This will shift the demand for the stock at all price levels.
For stock sellers, our analysis assumes that the capital gains taxes that investors face if they sell exceeds the capital gains tax that they anticipated facing when they originally purchased the stock. Investors face higher capital gains taxes than anticipated when their expected holding period exceeds their realized holding period. When this occurs, the sale accelerates the tax payment, and the seller loses the time value of money. The seller thus requires a higher price to sell the stock to recover the cost differential in the realized and anticipated capital gains taxes. This will move the supply of the stock at all price levels.
There are both theoretical explanations and empirical evidence supporting the assumption behind the lock-in effect. For example, Dammon, Spatt and Zhang (2001) document that in general investors may find it optimal to sell stocks with embedded capital gains to rebalance their portfolio if they are overweighed in equity. Specifically, they investigate how an investor’s liquidation policy and realization decisions depend upon the investor’s age, existing stock holding, and the tax basis on the stock holding. They find two offsetting forces jointly affect an investor’s realization decisions. On one hand, an investor would like to hold a balanced portfolio to capture the diversification benefit. On the other hand, because the tax on capital gains is forgiven at death (the tax basis is reset to the prevailing market price for the beneficiary), he also likes to defer realization of capital gains because of positive mortality rates throughout an investor’s lifetime.
Dammon, Spatt and Zhang (2001) find that for large embedded capital gains, investors retain their initial equity holding because the tax cost of rebalancing is too high. For somewhat smaller gains, young and middle-aged investors scale back their holdings of stock. In general, the amount of rebalancing depends upon the size of the embedded capital gain, the investor’s age, and the extent to which the investor’s existing portfolio deviates from the unconstrained optimum, which is the optimal equity holding when the investor can rebalance without triggering capital gains taxes. The unconstrained optimal holding of equity is age-dependent and reaches its maximum at a rather late age.
Their finding has implications for the relation between the expected and realized holding periods. To understand this relation, suppose that an investor starts from an optimal stock holding, given his age, current stock holding, and tax basis. His expected holding period will also be determined correspondingly according to the average stock returns going forward. However, if the stock experiences a larger price run-up than the investor anticipated, the investor’s equity proportion will exceed the investor’s optimal stock proportion according to the expected stock return going forward. The investor is now overweighed in stock for his situation. In this case, it is optimal for the investor to rebalance his portfolio by selling some stocks with embedded capital gains to move closer to the unconstrained optimum for his situation. Because the economy is populated with investors with different ages, stock holdings, and tax basis, at any given time, there are always investors rebalancing to move closer to their unconstrained optimum if their stocks enjoyed a large unexpected price run-up resulting in overweighed equity positions. In these cases, the investor’s realized holding period is shorter than his expected holding period for stock.
In their comparative static analysis, Dammon, Spatt and Zhang (2001) also find that a cut in the capital gains tax rate will result in realization of higher capital gains because the cost of rebalancing is reduced. This is particularly true for young investors who benefit the most from rebalancing. The implication of this finding is that in the case of a relatively surprising capital gains tax cut, such as the TRA 97, investors will be more willing to sell stocks with embedded capital gains to rebalance their portfolio ahead of their originally anticipated rebalancing. This also results in a shorter realized holding period than the expected holding period.
Other research also describes factors that can cause the realized holding period to differ from the expected holding period. Poterba (2001) documents that elderly investors with substantial appreciation in their portfolios tend to postpone the distribution of a larger proportion of their assets until after death compared to their contemporaries of similar wealth who possess smaller embedded capital gains. This is consistent with the explanation that an investor wishes to hold stock with embedded capital gains until death to avoid capital gains taxes.
Shackelford and Verrecchia (2002) analyze a related situation where buyers rationally compensate sellers to entice them to trade before they quality for long-term capital gains treatment. Under current law, gains on sales of stock held less for one year or less at taxed at 35 percent; gains held for more than one year at taxed at 15 percent. If a seller’s expected holding period exceeds one year, then his expected capital gains tax rate is 15 percent. To sell and face 35 percent short-term capital gains tax rates, the seller will demand a higher price. Shackelford and Verrecchia (2002) show that when news is released, prices move and some shareholders may find themselves deserving to rebalance. If they had expected to sell after qualifying for long-term treatment, they now must trade-off the risk of being over-weighted in an appreciated stock with the tax considerations of paying higher short-term capital gains rates. The result will be some trading, though less than would be optimal in the absence of capital gains tax rates. The trading will increase in the appreciation the shareholder enjoys and the spread between the long-term and short-term capital gains tax rates. Blouin, Raedy, and Shackelford (2003) provide evidence, consistent with the theory in Shackelford and Verrecchia (2002). They examine price changes around earnings announcement and additions to the S&P 500 during the 1980s and 1990s and find prices rising on the news for investors nearing qualification for long-term treatment, as predicted.
Poterba and Weisbenner (2001) link the January effect to these differences in short and long term capital loss tax rates. Reese (1998) shows that prices increase just before investors who receive shares in an IPO qualify for long-term capital gains treatment. Both are consistent with the assumption that an investor’s expected holding period may exceed their realized holding period.
To demonstrate the effect of capital gains tax on stock price, we use an equilibrium approach based on the demand and supply framework. We assume that the demand curve for the stock is downward-sloping so that investors are willing to buy more shares of the stock at lower prices and fewer shares at higher prices, and on the other hand, the supply curve is upward-sloping so that investors are willing to sell more shares at higher prices and fewer shares at lower prices, both before and after the capital gains taxes.
Figure 1 illustrates the effect of a capital gains tax change on stock price and the interaction between the two opposing forces: capitalization and lock-in. To facilitate the discussion in our empirical analysis, we examine the effect on stock price of a capital gains tax cut. At first, suppose that the initial capital gains tax rate is . The demand and the supply for any particular stock are depicted as D and S in the graph and the two intersect with each other at point A, which determines the equilibrium price and float of shares . Now, we introduce a capital gains tax cut from to and . The demand curve shifts to the right from D to D’ due to increase in demand associated with the capitalization effect. At the same time the supply curve also shifts to the right from S to S’ due to increase in supply associated with the lock-in effect. In equilibrium, the new demand and supply curves intersect with each other at point B, which provides us with a new equilibrium price, , and a new float of shares, . It is obvious that the new price could be higher or lower depending upon which effect dominates. However, the float of shares is clearly increased. In the event of a capital gains tax increase, the shift in demand and supply is reversed. Consequently, the float of shares is unambiguously decreased. However, the change in equilibrium price remains ambiguous depending on which effect dominates: the capitalization or the lock-in. In the appendix, we formalize the demand and supply analysis and analytically demonstrate the effect of capital gains taxes on stock price to be ambiguous depending upon the relative magnitude of the capitalization to that of the lock-in.
[INSERT FIGURE 1 ABOUT HERE]
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 (higher current stock returns). This will arise when buyers are more responsive to an imminent capital gains tax cut than are current sellers. 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 (lower current stock returns). This will happen if current sellers are more responsive to the capital gains tax cut than are buyers. Second, the float of shares is inversely related to the capital gains tax rates. 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.
Because of different effects of capital gains taxes on stock buyers and sellers, stocks with different characteristics will also be affected differently in the event of a capital gains tax change. Growth stocks are expected to offer larger future price appreciation than income stocks. A capital gains tax cut will reduce the buyer’s future tax liability and attract more demand. These stocks will experience a greater price increase and higher returns than income 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 likely higher for non-dividend paying firms than dividend paying firms. From a stock seller’s perspective, tax sensitive investors holding stocks with large long-term price appreciation will have lower current tax costs upon selling when the capital gains tax is reduced. Thus, tax sensitive investors will be more inclined to sell stocks with large embedded capital gains to rebalance their portfolio. This implies that in the event of a capital gains tax cut, stocks with large embedded capital gains 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 addition, investors anticipating the capital gains tax cut may withhold selling shares with embedded gains before the tax cut becomes effective (seller’s strike). In this case, the supply curve may remain unchanged or even move up from S to S’’. The demand and supply curve may intersect at point C or D. This will lead to a temporary increase in both the stock price and float of shares. This may provide an alternative explanation to a dominating capitalization effect before the capital gains tax cut becomes effective. 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, including a possible alternative explanation for capitalization effect (seller’s strike).