Working Paper: NBER ID: w12342
Authors: Zhonglan Dai; Edward Maydew; Douglas A Shackelford; Harold H Zhang
Abstract: 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 demand and supply 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. Nondividend 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 tax sensitive investor ownership exhibit lower average returns during the week the lock-in effect dominates. We also find that the tax cut increases the trading volume during the week immediately before and after the tax cut becomes effective and in stocks with large embedded capital gains and high tax sensitive ownership during the dominant lock-in week.
Keywords: capital gains tax; asset prices; capitalization effect; lock-in effect
JEL Codes: H2; G1; D4; M4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Reduction in capital gains tax rate (H24) | Increase in asset prices (G19) |
| Reduction in capital gains tax rate (H24) | Increase in demand for stocks (G17) |
| Reduction in capital gains tax rate (H24) | Decrease in supply of stocks (G10) |
| Capitalization effect (G31) | Increase in asset prices (G19) |
| Lock-in effect (E43) | Decrease in asset prices (G19) |
| One standard deviation increase in five-year embedded capital gains (E22) | 25% reduction in weekly returns during lock-in week (G12) |
| Tax cut (H29) | Increase in trading volume (F10) |
| Tax-sensitive ownership (H24) | Increase in trading volume (F10) |
| Stock characteristics (embedded capital gains) (G12) | Influence on effects of capital gains tax (H31) |