Capital gains taxes and equity prices.

• Author: Shackelford, Douglas A.
• Position: Research Summaries

The extent to which individual shareholders' taxes affect equity, prices is central to valuation and tax policy. Historically, the dividend tax has attracted more scholarly, attention than the capital gains tax. Even today, the debate between the traditional view and the (now not-so-new) new view continues, and studies of the 2003 reduction in the dividend tax are already emerging. (1)

Conversely, the appropriate tax on capital gains has long been hotly contested in policy circles but has received comparably little attention from scholars. This is surprising because most companies pay no dividends and those that do pay dividends typically distribute only a small fraction of their profits. Thus, the capital gains tax would appear to be more important for investors than the dividend tax. In recent years scholars have become increasingly interested in the impact of the capital gains tax on share prices. This report summarizes some of that recent research.

Necessary Conditions for Share Prices to be Affected by Taxes

When an investor sells a share of stock, the United States taxes the difference between the sales price and its tax basis, which is usually the purchase price. Except for the period 1988-90, individual investors have been rewarded with a reduced tax rate if they hold the stock for a minimum period, which has ranged from six to 18 months. Currently the appreciation on investments held for more than one year (long-term capital gains) is taxed at a maximum rate of 15 percent while the appreciation on investments held for shorter periods (short-term capital gains) is taxed at the ordinary tax rate, currently capped at 35 percent.

Policy debates about the level and appropriateness of capital gains taxes almost always revolve around the long-term capital gains tax rate and the length of the requisite holding period. Since changes in these policies often provide added power to our tests of the impact of capital gains taxes on share prices, let's consider the necessary conditions for a change in the long-term capital gains tax rate to affect share prices. (2) To begin with, the marginal investor in the firm must be an individual or a flow-through entity that passes capital gains to individual tax returns. If other investors (for example, qualified retirement plans, corporations, tax-exempt organizations, or foreign entities) are setting prices, then changes in the long-term rate should have no effect on prices because preferential rates for long-term gains only apply to individuals.

Furthermore, the marginal investor must be willing to hold the stock for the obligatory long-term holding period, must dispose of the stock in a taxable manner (for example, not as a charitable donation or bequest), must intend to comply with the law (capital gains non-compliance is known to exceed that of wages, dividends, interest, and many other sources of income), (3) and must not have anticipated the tax rate change. In addition, because of complex netting provisions, the long-term capital gains tax rate applies if and only if an individual's long-term capital gains during the year exceed his long-term capital losses and the excess of his short-term capital losses over his short-term capital gains, if any. (4) Finally, inelasticities in the supply of capital must prevent immediate readjustment throughout the economy following the tax rate change.

All of these conditions must hold for a change in the long-term capital gains tax rate to affect prices (other than through indirect macroeconomic shifts). Similar conditions must hold for other changes in the taxation of capital gains to affect share prices. Thus, it is an empirical question whether changes in capital gains taxes affect share prices.

The remainder of this article reviews recent research designed to provide some empirical underpinning. In general, the preliminary evidence suggests that capital gains taxes affect equity prices and may contribute to short-term departures from fundamental prices. An implication of these findings is that changes in capital gains taxation affect firms differently depending upon the composition and preferences of their investors. For example, the results suggest that two firms, identical in all regards, except the tax treatment of their investors, could have different prices (at least temporarily).

Challenges to Empirical Work

Estimating the influence of personal capital gains taxes on equity prices is challenging because of both theoretical and empirical limitations, First, the theory struggles to provide adequate guidance and structure. The reason lies with the realization principle that underpins capital gains taxes. Shareholder capital gains taxes are triggered by trades in the secondary market, share...