1

Capital Gains Taxation: Recent Empirical Evidence

Kevin Mill igan, Jack Mintz, and Thomas A. Wilson

University of Toronto

Prepared for The Heward Stikeman Institute

September 1999

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Executive Summary

This paper reviews recent empirical evidence on the economic effects of capital gains

taxation. We focus on two issues. First, we examine the effects of changes in capital

gains taxes on government tax revenues. The balance of the evidence suggests that while

a decrease in the capital gains tax rate may lead investors to rebalance their portfolios

more frequently, the increased volume of capital gains realizations will be insufficient to

offset the revenue loss from the lower rate. This is especially true in Canada because of

the deemed disposition of capital assets at death. For 1996, we calculate rough estimates

for the federal government revenue loss in response to a reduction in the capital gains

inclusion rate from 3/4 to 2/3. We find an upper bound of $400 mill ion. If there is an

increase in capital gains realizations in response to the reduction in the rate, the revenue

cost would of course be lower.

Beyond the budgetary considerations, changes in capital gains taxes can have important

effects on investment in the economy. We examine evidence relating to the effect of

capital gains taxes on firms’ cost of capital, which plays a critical role in firms’ decisions

about productive investment. Even in a world with large tax-exempt entities (such as

pension funds) and some degree of international capital mobility, taxes do appear to have

an impact on the cost of capital for firms. We use the results of recent research to

calculate that a reduction in the inclusion rate from 3/4 to 2/3 could increase investment

by as much as 2%.

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1.0 INTRODUCTION

The tax treatment of capital gains once again is of policy interest in Canada.

Pressure for change arises from both internal and external sources. Within Canada, the

fiscal surpluses projected for the imminent future present an opportunity to change the

structure of taxation as the overall level of taxation is lowered. From outside Canada,

recent reforms to capital gains taxes in the United States have increased the difference

between the two countries’ treatment of capital gains. The taxation of capital gains raises

several issues: the tax rate applied to gains, indexation of the tax base for inflation, the

treatment of losses, and the lock-in effect on portfolio holdings. To better frame the

policy discussion on this issue, we review in this paper recent contributions to the

empirical literature on the economic effects of capital gains taxation.1

The empirical approaches used in capital gains studies have become more

focused. Zodrow (1993) provides a detailed accounting of the advantages and

disadvantages of different empirical approaches common in the literature. Researchers

employing macrodata study aggregate statistics through time and across jurisdictions in

order to learn about the economic effects of policy. On the other hand, microdata

analysis uses data on the behaviour of individuals either in cross sections or through time.

Zodrow expresses skepticism about the ability of microdata to account for unobservable,

yet influential, individual-specific patterns in behaviour that may drive observed results.

However, there has been a distinct movement in the direction of microdata in the

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empirical literature, as noted by Slemrod (1998). A common thread through much recent

work is the attempt to exploit ‘natural experiments’ that enable researchers to observe the

same individuals under different policy regimes.2 This allows researchers to separate the

effect of policy from traits of personality.

This paper first examines the impact of capital gains taxation on government tax

revenues. This involves consideration of the sensitivity of capital gains realizations to the

capital gains tax rate. Next, we describe the evidence on the effect of capital gains on

firms’ cost of capital, which represents one of the major potential efficiency-enhancing

effects of capital gains tax cuts. The paper concludes with a summary of the evidence.

1 A review of empirical evidence on capital gains taxation appeared in Zodrow (1993). This was partiall yupdated in a subsequent article, Zodrow (1995). The present paper takes Zodrow (1993) as its point ofdeparture, looking only at research since that time.2 Different researchers attach different labels to this general approach. Natural experiments,quasiexperiments, event studies, and difference-in-differences methodologies are described in detail inMeyer (1995).

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2.0 REALIZATIONS

An active research literature has investigated the consequences of changes in

capital gains tax rates on government tax revenues. In 1996, taxable capital gains in

Canada amounted to $6.9 bill ion, only 1.4% of the total taxable income for individuals in

that year. Burman and Ricoy (1997) report that taxable capital gains taxes averaged 6%

of total assessed income from 1979 to 1988 in the United States. Given these numbers,

the attention given to the effect of capital gains tax rates on revenues seems out of

proportion to its importance in the revenue structure. This abnormal attention likely

arises from the tempting possibil ity that rate cuts could lead to increases in revenues – the

seductive appeal of the Laffer Curve.3 If true, the ‘f ree lunch’ of a revenue-enhancing

improvement to economic efficiency would make capital gains tax cuts a desirable policy

reform.

3 The Laffer Curve derives its name from Arthur Laffer, who popularized the notion that cuts to tax ratesmay generate more than offsetting increases in the tax base, producing an increase in tax revenue.

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Table 1

Capital Gains and Taxable Income, 1993-1996

Year Net Realizations

($1000’s)

Taxable Income

($1000’s)

Percentage

1996 6,932,585 480,498,568 1.44%

1995 4,207,944 463,570,335 0.91%

1994 4,275,541 444,404,614 0.96%

1993 3,989,621 435,466,112 0.92%

Net reali zations refers to taxable capital gains less capital gains deductions.4 Taxable Income refers to totalassessed taxable income. Percentage refers to net realizations divided by the taxable income for each year.All data from Statistics Canada (1993-1996).

Before examining the empirical evidence on the question of how revenue

responds to capital gains tax cuts, it is important to understand the mechanism through

which this occurs. This is particularly relevant for the case of Canada. Because Canada

deems assets to be disposed at death, all unrealized gains must be realized within the

4 From 1985 to 1994, there was a $100,000 lifetime capital gains exemption available to all investors.Owners of shares in Canadian Controlled Private Corporations and farm property continue to have accessto a $500,000 li fetime exclusion.

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horizon of a li fetime 5 (or two6). The only way capital gains tax cuts can increase the

present value of government revenues is by raising the rate of asset turnover within the

portfolio, meaning that gains would be realized more often. So, rate cuts affect revenues

only to the extent that the taxes on more frequent realizations exceed the taxes that would

have been collected with infrequent realizations. In this way, a large fraction of any new

revenues generated by a rate cut represents a shifting of tax revenue from the future to the

present, rather than a true increase in government revenues.

Mintz and Wilson (1995) explore this issue in more depth. They develop a

methodology to calculate the present value of changes in capital gains rates under

Canada’s deemed disposition tax system. Using this methodology, they estimate the

revenue cost of the $100,000 lifetime capital gains exemption available to Canadian

taxpayers from 1985 to 1994. The total net present value of the loss of the stream of

revenue is estimated to be 4.5 bil lion dollars. This is much less than estimates not

considering these important intertemporal issues.

Mariger (1995) simulates capital gains realizations within a framework similar to

Canada’s deemed disposition at death rules. In the simulations, Mariger finds that large

variations in the rate of asset turnover produce only small variation in the ratio of realized

5 In the United States, capital assets passed through an estate are not taxed, and have their cost basisupdated to fair market value at the time of death. However, estate taxes may apply to assets transferredthrough an estate.6 In Canada, assets gifted or bequeathed to a spouse are not subject to deemed realization; however, the costbasis of the asset is not increased. Certain farm properties have similar treatment when bequeathed tochildren.

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gains to accruals.7 The ratio ranges between 0.73 and 0.91 for asset turnover rates varying

from 0.20 to 1.00 per annum. This suggests that a change in the capital gains tax rate

would have to exert very strong influence on the rate of asset turnover to have even a

moderate influence on the government’s intertemporal budget constraint. How strongly

turnover reacts to capital gains tax rates depends crucially on the lock-in effect of taxes

on portfolio choices. Accordingly, we begin by reviewing the evidence on how the lock-

in effect influences portfolio decisions.

2.1 Lock-in Effect

The lock-in effect has been a primary focus of capital gains research. Because an

asset with a low cost basis wil l attract a large capital gains tax liability if the asset is

disposed, investors find it optimal to stay ‘ locked in’ to assets with a low cost basis. As

stressed by Mariger, the strength of the lock-in effect determines the rate of asset

turnover, which in turn determines how revenue responds to tax rates. If there is no lock-

in effect, changes in capital gains tax rates will serve to reduce revenue both at present

and in the future. Below we examine two studies of the influence of the lock-in effect on

economic decisions.

LANDSMAN & SHACKELFORD (1995)

Landsman and Shackelford (LS) confirm the existence of lock-in effects by

7 In his model, the maximal tax base would be the annual accrued capital gain. Comparing actualrealizations to this maximal tax base shows the proportion of the potential tax base that is captured by the

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studying a particular firm through a unique circumstance. In 1988, RJR Nabisco

underwent a leveraged buyout by its management. Through their direct access to detailed

shareholder records, LS are able to measure the cost basis of each shareholder's holdings.

This information is used to test hypotheses related to the lock-in effect.

LS report two key findings. First, the cost basis of the shares played a role in

determining a shareholder’s choice among the options offered by the buy-out group. One

option offered strictly cash, meaning that shares were subjected to immediate taxation.

Another option offered preferred shares and debt in exchange for outstanding shares. This

enjoyed a more favourable tax treatment, as capital gains could be deferred. The average

cost basis of those choosing the exchange option was $19, compared to $49 for those

taking cash. This is consistent with the hypothesis that those with a lower cost basis

should prefer the tax-favoured option. The second finding relates to the selling price

required by investors holding shares with different cost bases. During the period from

the time the offer was announced until the day the offer closed, LS find a negative

relationship between the cost basis of shares sold on a particular day and the day's price.

In other words, those holding shares with low cost bases were more likely to realize their

gains on days when the price was high. This suggests that those with the largest accrued

gains (i.e. with the lowest cost bases) may have had systematically higher minimum

selling prices in order to compensate them for their larger capital gains liabil ity.

government.

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REESE (1998)

Without special access to shareholders’ records, it is very diff icult to observe the

cost basis for shares sold in the market, rendering empirical study of the lock-in effect

difficult. Reese finds a novel way to measure the cost basis of asset holdings by studying

initial public offerings (IPOs). For IPOs, both the date and initial cost of the stock is

known. Reese exploits this feature of IPOs in order to measure the importance of the

lock-in effect for the realization decision.

Before the Tax Reform Act of 1986 (TRA86), long-term capital gains (realized

gains on assets held longer than one year) quali fied for favourable tax treatment relative

to short-term gains. This provided an incentive for taxable shareholders to delay

realizations for stocks that had appreciated, but to speed up realizations for stocks that

had depreciated. Reese tests these hypotheses using data on 968 IPOs from 1976 to

1986, and 1140 IPOs from 1989-1995. Since the favourable capital gains tax rate on long

term gains disappeared after TRA86, comparing results from the two datasets will help

isolate the effect of the tax provisions.

Reese finds that trading volume on stocks that had appreciated one year after the

IPO increased by approximately 10% during the week following qualification for the

long-term rate. Trading volume for stocks with losses after one year was significantly

higher in the week preceding qualification for the long-term rate. Reese repeats the

analysis for the period surrounding qualification using returns. The results are similar.

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There was a significantly lower abnormal return to appreciated stocks in the week

following quali fication, and for depreciated stocks in the week preceding qualification.

This is consistent with his hypothesis that tax considerations motivated the timing of the

selling of these shares. Shares with losses were sold while still eligible for the larger

deduction available with the short-term rate, while shares with gains were not sold until

the long-term rate applied. Importantly, all the above effects disappeared with the

removal of the differential long-term rate after TRA86.

JOG (1995)

Jog examines Canadian evidence of the impact of the lock-in effect by studying

the introduction of the lifetime capital gains exemption in 1985. This exemption allowed

$100,000 of capital gains to be realized without being taxed.8 Using aggregate taxpayer

data, Jog documents an increase in total realizations, the proportion of taxfilers reporting

capital gains, and the proportion of taxfilers with dividend income. During the same time

period, no similar trends emerge in the United States. Jog interprets these data as being

consistent with an ‘unlocking’ of accrued capital gains and an increase in stock market

participation. Jog is careful about making claims of causation about the observed trends

and the introduction of the li fetime capital gains exemption. Because he is unable to

control for other factors that may be influencing his data, his caution is justified. Still, this

data provides some evidence that the lock-in effect does influence portfolio choice in

Canada.

8 The limit was originall y $500,000. There were also changes in the assets quali fied to be included in theexemption during through the years it existed. The details can be found in Jog (1995).

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On the whole, this evidence strongly suggests that capital gains taxes can affect

portfolio and realization decisions. Is the strength of this effect sufficient to allow capital

gains tax cuts to generate higher tax revenues? We now address this question.

2.2 Revenue Effects

The question of how government revenue responds to capital gains tax changes

has been the subject of a large literature. These studies focus on the responsiveness of

capital gains realizations with respect to changes in the capital gains tax rate – the

elasticity of realizations. The elasticity of realizations is defined as the percentage

increase in the tax base divided by the percentage reduction in the tax rate. Tax revenues

will rise (fall) if the percentage increase in the base induced by the rate reduction is

greater (less) than the percentage decrease in the rate. Thus, if the elasticity is more (less)

than one, a decrease in the rate will increase (decrease) revenues. For this reason, most

studies focus on the comparison of estimated elasticities to one.

There are a number of reasons why a simple comparison of estimated elasticities

to one may be misleading. Gill ingham and Greenlees (1992) emphasize that with a

progressive income tax, realizations may push taxpayers into a higher tax bracket. If this

is the case, then an elasticity lower than one may be sufficient to bring about a revenue

neutral rate cut. The lack of progressivity in the Canadian income tax at high income

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levels may diminish the impact of this argument in Canada.9 Gravelle (1995) points out

the importance of revenue feedback effects. For example, lower capital gains taxes might

change corporate distribution policies. This would have impact on taxes collected from

dividend payments. Accounting for these types of induced tax effects complicates the

interpretation of the realizations elasticity. Below, we examine three recent empirical

studies of capital gains realizations. At the time of Zodrow (1993), drawing clear

conclusions from the available evidence was difficult. This is no longer the case, as new

results have laid the groundwork for consensus on this question.

BURMAN AND RANDOLPH (1994)

This landmark study reconciled the seemingly disparate results of previous

research. As noted by Zodrow, past studies using aggregate macrodata tended to find

realization elasticities closer to zero than one, while those using microdata found

realizations to be much more responsive to capital gains tax rates. Burman and

Randolph’s innovation was to empirically identify separate temporary and permanent

responses to changes in capital gains tax rates. With a progressive income tax and

income varying from year to year, realizing capital gains in low income years allows for

some degree of tax base smoothing. By ignoring this possibility, previous studies using

microdata overstated the sensitivity of realizations to tax changes.

9 In 1996, 64% of the total dollar value of capital gains realizations were made by taxpayers with over$100,000 in income. The income tax is strictly proportional in this range for taxpayers from any province.

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A problem common to all microdata studies of realizations behaviour is properly

measuring the effect of the marginal tax rate. Realizations affect the marginal tax rate,

while the marginal tax rate may also influence realizations. This feedback effect imperils

inferences from standard econometric techniques. To overcome this endogenous variable

problem, Burman and Randolph (BR) use an instrumental variables estimator. For the

permanent tax rate, they use the applicable top statutory combined state and federal rate

on capital gains as an instrument. This is unlikely to be correlated with individual

transitory income shocks, but will be correlated with the individual’s tax rate. Because

of this, the top combined rate can be used to uncover an unbiased estimate of the effect of

taxes on realizations. However, if the state of residence decision depends on capital gains

tax rates, this instrument may be problematic.10 BR also require an instrument for the

transitory marginal tax rate faced by the individual. The marginal tax rate on the last

dollar of other income (excluding capital gains) serves this purpose.11 This tax rate will

be correlated with the true marginal tax rate facing the individual, but will not depend on

capital gains realizations.

Armed with these instruments, they estimate a two-step regression on a panel of

approximately 11,000 taxpayers through the years 1979 to 1983. The first stage of the

regression predicts whether or not an individual will realize any capital gains, given

individual characteristics and the predicted tax rates. The results from this regression are

10 The potential endogeneity of the state residence decision with capital gains tax rates is discussed in moredetail below in reference to the study by Bogart and Gentry (1995).11 Triest (1998) discusses methodological concerns with the use of first-dollar marginal tax rates asinstruments.

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used in the second stage in order to estimate the magnitude of capital gains that are

realized.

The results are striking. The point estimate of the permanent realization elasticity

is 0.18, with a standard error of 0.48. This is indistinguishable from zero. However, the

point estimate for the transitory elasticity is 6.42, with a standard error of 0.34. This is

much larger than found in previous studies. When the permanent marginal tax rate is

omitted from the specification, the estimate for the transitory marginal tax rate becomes

4.19. This estimate is closer to the results found in previous microdata studies,

suggesting that the omission of the permanent tax rate caused previous studies to

underestimate the short-run sensitivity of realizations to the tax rate.

The instruments in this study are imperfect and the panel is short.

Notwithstanding these faults, this paper does much to reconcile the debate about capital

gains realizations elasticities. This evidence suggests that while capital gains realizations

are very sensitive to rates in the short run, the long run sensitivity may be quite small.

BURMAN, CLAUSING, AND O’HARE (1994)

The Tax Reform Act of 1986 (TRA86) presented a natural experiment to tax

researchers. Burman, Clausing, and O'Hare (BCO) exploit this reform to examine

transitory capital gains realizations. Before the reform, the tax rate applicable to capital

gains realizations depended on the length of time the asset had been held. Long-term

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capital gains were taxed at 20%, while short-term capital gains were taxed at rates up to

50%. After the reform, no distinction was to be made between long- and short-term

gains, with both being taxed at a 28% rate.

If TRA86 had arrived in the form of a surprise decree from the tax authority,

identifying the effect of the reform on realization behaviour would have been much

simpler. However, in a congressional system with many centres of power, the journey of

TRA86 into law was full of twists. From the original proposal by the U.S. Treasury

Department in 1984 to its signing by President Reagan in October of 1986, it went

through many changes in content, and its eventual implementation was never certain.

BCO develop a model to explain how realizations of short- and long-run gains

and losses should react to the announcement. They test the implications of their model

on a panel of taxpayers. In the panel are taxpayers who sold capital assets, with rich data

on the sale price, cost basis, and asset class.

BCO include dummy variables for weeks following various important milestones

in the legislative path followed by TRA86. This facil itates the isolation of the effect of

these announcements on realizations from other influential factors, such as the ebbs and

flows of the stock market. TRA86 proposed an increase in the rate on long-term gains,

while the rate on short-term gains was to drop. For an investor wishing to minimize

taxes, losses should be realized when rates are higher and gains when rates are lower.

Consistent with this model, BCO find that as the final form of TRA86 took shape,

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realizations of long-term gains and short-term losses accelerated, while realizations of

short-term gains dropped. The behaviour of long-term loss realizations did not show any

reaction to the legislative announcements.

Following their regression analysis, they present aggregated net realizations for

different types of taxpayers and different asset classes through the time period of the

reform. This aggregate data is strongly consistent with their model. For example, the

dollar value of long-term capital gains realizations of corporate stock in December 1986

was seven times the level of the previous December. This suggests that taxpayers with

unrealized long-term gains preferred to realize them at 20%, rather than face the higher

long-term rate in the future.

Trying to capture announcement effects and changes in expectations is always

difficult because of problems separating the desired effects from contemporaneous

shocks. Although BCO control for current and lagged macroeconomic variables,

investors’ expectations about crucial future variables are not available. This complicates

interpretation of their regression evidence, which on its own, is not completely

convincing. However, the evidence in the aggregated data bolsters their argument.

Given these patterns of realizations through this period of reform in 1986, it seems a safe

conclusion that future capital gains tax rates can have a substantial effect on realizations

behaviour. This provides further evidence about the importance of distinguishing

between transitory and long term revenue impacts when discussing capital gains

realizations elasticities.

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BOGART AND GENTRY (1995)

Bogart and Gentry (BG) take a fresh approach to the use of macrodata to estimate

the realizations elasticity. Previous macrodata studies received criticism for making

inferences from small datasets that included very li ttle variation in the tax rate. BG

overcome these two problems by disaggregating realizations data to the state level.

Looking at 51 jurisdictions within the U.S. over 12 years provides a much larger sample

size. Equally important, there is much variation both across states and through time in the

capital gains tax rate. This variation allows for greater confidence in the results.

Using interstate variation to identify the realizations elasticity requires that capital

gains decisions be independent of state residence decisions. BG assert that factors other

than capital gains tax rates weigh much more heavily in the state residence decision. This

does seem plausible, but it is insufficient. If a state’s capital gains tax rate is correlated

with some excluded variable that does exert influence on the state residence decision,

then BG’s assumption of exogeneity fails. An excluded variable that fits this description

might be a state’s overall level of taxation. Capital gains tax rates are not likely to be

randomly distributed across states, but instead may be correlated with a state’s overall tax

level. For the interstate variation in capital gains tax rates to be exogenous in this case,

the state residence decision must be independent of the overall tax stance of the

jurisdiction. This may be true, but it is a stronger condition than what BG discuss.

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BG estimate different specifications to try and control for heteroskedasticity, and

to see the effect on their results of the inclusion of future and past tax rates. Their

preferred specification (including random year effects) produces an estimated capital

gains realization elasticity of 0.645. A 95% confidence interval around this estimate does

not include one. This result is strongly robust to different error structures and the

inclusion of past and future tax rates, with other estimates ranging from 0.633 to 0.686.

When some years are excluded, or state effects are introduced, the result appears much

less robust. This is not surprising, as the smaller time periods exclude much of the time

variation in rates, and the inclusion of state effects weakens the abil ity of interstate

variation to identify the elasticity. The methodology employed by BG represents a

substantial improvement on previous macrodata studies. Their results empirically bound

the realizations elasticity away from one, and this result is convincingly robust.

2.3 Summary

The literature on capital gains realizations has matured. The work by BR and

BCO emphasizes the crucial importance of separating short-run from long-run effects.

The methodology of BG succeeds in extracting as much as may be possible from a

macrodata analysis. This evidence convincingly bounds the long run elasticity higher to

be less than one. In addition, Mariger’s simulations provide an important caveat for

countries in which capital gains must be realized at death – any increases in current

revenue will decrease future government revenue. Overall , from the available evidence,

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a claim that capital gains tax cuts will be self-financing in the long run cannot be

supported empirically.

The results of the research discussed in this section can be used to obtain a rough

estimate of the revenue cost of a particular policy reform. In 1996, net taxable capital

gains realizations by individuals were $6.6 bill ion. Based on Finance Canada’s Tax

Expenditure estimates, net federal revenues for personal capital gains taxes were about

$2.0 bill ion. Taxable capital gains realized by corporations generated an additional $1.8

bill ion of federal revenue.12 Now consider a cut in the capital gains inclusion rate from

75% to 66 2/3%. With no change in realizations, this would cause a drop in federal

revenues of about $0.4 billion. However, if realizations increase as a result of the lower

tax rate, then the increase in tax base would partially offset the drop in the tax rate,

leading to a smaller net revenue loss.

From the American studies discussed above, an elasticity of 0.5 seems a

reasonable upper bound on the long run elasticity, although the short run elasticity could

be much larger, possibly greater than one. However, as mentioned earlier, Mintz and

Wilson (1995) indicate that results from American studies have only limited application

to the Canadian case because of the differing treatment of capital gains at death.13

Also, any reduction in capital gains taxes paid by corporations should generate a

partial offset through increased income taxes on dividends and/or capital gains at the

12 See Finance Canada, Tax Expenditures 1999, Tables 1 and 2.13 With deemed disposition at death, part of the increase in tax base represents realizations that are shiftedfrom a future year to the current year, rather than a true increase in li fetime realizations. Furthermore,none of the studies reviewed dealt with realizations of capital gains by corporations.

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personal level. Making some allowance for both of these factors would reduce the

revenue cost of this tax change to about $0.3 bill ion.

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3.0 INVESTMENT

One important channel through which capital gains taxation influences economic

eff iciency is the effect on firms' cost of capital. If the cost of capital paid by a firm

decreases, then the firm wil l undertake more investment projects. With increased

investment comes higher living standards and better employment. In this way, capital

gains taxes can be linked very directly to tangible measures of welfare.

Capital gains taxes influence a firm’s cost of capital by changing the rate of return

required by the marginal investor in the firm's equity. If taxes change the required return,

then the price the marginal investor is willing to pay for a share of the future stream of

the firm's earnings will change. Because of this, the capital gains tax would be

capitalized into the price of the share. If personal taxes on the firm’s income are

increased (decreased), the price of the share falls (rises). So, the response of equity prices

provides direct evidence of how firms' cost of capital changes with capital gains tax rates.

If Canadian markets are small relative to the world, and if capital may flow freely

across borders, then the return required by the marginal investor will be determined by

world market conditions outside the influence of Canadian tax policy. This implies that

domestic capital gains taxes would have no impact on required rates of return. This ‘ tax

irrelevance’ view, associated closely with Mil ler and Scholes (1982), holds if the

marginal investor is, for example, a tax-exempt entity like a pension fund, an investor

from abroad not subject to domestic taxes, or anyone facing the same effective rate of

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taxation on dividends and capital gains. This section wil l examine evidence of the impact

of domestic taxes on equity prices in order to infer the role of capital gains taxes in

determining firms' cost of capital.14 If taxes do not affect equity prices, then changes in

capital gains tax rates will have no influence on firms’ cost of capital, and so no effect on

investment. However, if taxes do have a large effect on equity prices, then changes in

capital gains tax rates will change firms’ investment decisions.

3.1 Ex-day price effect

Researchers have identified an intriguing experimental setting in which to

examine the influence of domestic personal taxes on equity prices. Typically, firms

announce the size and the date of a dividend in advance. The day before dividends are

paid (referred to as the cum-dividend day), a purchaser of a share will be entitled to the

dividend. A purchaser of the share after the day the dividend becomes payable (the ex-

dividend day), will not receive the dividend.

In a frictionless capital market without taxes, one expects to see the price of the

share drop on ex-day by exactly the amount of the dividend. If this were not the case, a

trader following a dividend capture strategy could profit. Such trading would take the

following form. A trader buys the stock cum-dividend at the prevailing market ask price,

14 A large literature examines the role of dividend taxes on firms’ cost of capital. Zodrow (1991),McKenzie and Thompson (1996), and Head (1997) review this literature, each with a different focus.Boadway and Bruce (1992) argue theoreticall y that integration of corporate and personal taxation isirrelevant in a small open economy. Devereux and Freeman (1995) provide empirical evidence suggestingdividend taxes do matter. McKenzie and Thompson (1996) come to the same conclusion in their review ofthe empirical literature on this question.

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holds the stock long enough to earn the dividend, then sells it ex-dividend at the

prevail ing bid price. So, in the absence of profitable dividend capture trading

opportunities, the price of the share should drop by exactly the amount of the dividend on

ex-day. Elton and Gruber (1970) documented empirically that this was not the case –

prices dropped by less than the amount of the dividend on ex-day. This spawned a

literature attempting to document the magnitude of the ex-day effect, and to separate

competing hypotheses explaining its presence.

The tax explanation for the ex-day effect is related to the relative tax treatment of

dividends and capital gains. If dividend-capture traders are subject to taxation, the no-

arbitrage condition becomes

( ) ( )( )cgxcdiv PPD ττ −−=− 11 ,

where D is the magnitude of the dividend, Pc and Px denote the cum-dividend and ex-

dividend prices, and τdiv and τcg represent the effective tax rate on dividends and capital

gains. Rearranging this leads to

( ) ( )( )cg

divxc

D

PP

ττ

−−=−

1

1.

From this expression it is clear that a price drop of less than the dividend could reflect a

lower effective tax rate on capital gains than on dividends.

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LASFER (1996)

This paper examines British data on the ex-day price effect. It looks at 108

industrial and commercial companies between 1979 and 1983, a period in which

dividends were taxed heavily relative to capital gains. First, Lasfer establishes the

existence of an ex-day price effect. The firms exhibited an average excess pre-tax return

on ex-day of 1.90%, which is significantly different from zero. Because there are no

significant excess returns on days preceding or following ex-day, the author suggests that

tax considerations are the most likely cause.

The absence of policy reforms over the period under consideration weakens the

credibil ity of the attribution of the ex-day effect to taxes. Common with earlier efforts in

this literature, the approach taken to identify taxation as the cause of the ex-day effect is

to rule out other potential explanations, leaving taxes as the residual explanation. This

approach is not fully convincing.

A further test is applied to the excess returns using information on dividend

yields. If the excess return is explained by dividend taxes, then stocks with higher

dividend yields should exhibit stronger excess returns on ex-day, since the higher taxed

dividends figure more prominently in the firm's distributions. The excess return is

regressed on the dividend yield and a measure of the firm's size, uncovering a strong,

positive effect. However, if high dividend yield firms differ from low dividend yield

26

firms in ways that are correlated with the ex-day excess return, then the failure to control

for these other factors would bias the coeff icient on the dividend yield. The absence of

these controls leaves unknown the robustness of this result. Still, this regression provides

evidence that is consistent with taxes explaining some part of the ex-day price effect.

LAMDIN AND HIEMSTRA (1993)

Lamdin and Hiemstra (LH) exploit TRA86 to identify the effect of personal taxes

on the ex-day price effect. The tax reform dropped the top tax rate on dividends from

50% to 28%, while capital gains taxes on long-run gains increased from 20% to 28%.

Because the taxation of dividends relative to capital gains dropped unambiguously, the

tax hypothesis predicts that the ex-day price effect should be smaller after TRA86.

LH use a large sample of firms from the CRSP database over the period 1982 to

1991. They focus on the ratio of the price change to the amount of the dividend. The

mean of this ratio increases from 0.885 in 1982-1986 to 0.918 in 1987 to 1991. The t-

statistic for the hypothesis that the difference in these means equals zero is 2.06. So, this

suggests that TRA86 had a significant effect on the ratio of the price change to the

dividend, consistent with the predictions of the tax explanation for the ex-day effect.

While the change in the ratio is certainly consistent with the tax explanation, other

factors could be underlying the observed result. The authors discuss and reject other

possibilities for this change in the ratio. For example, any change in transaction costs,

27

risk, or other non-tax factors during this period could have affected the will ingness of

investors to undertake dividend capture trading. Their rejection of other explanations

may be unsupportable, however, given the evidence provided by Koski (1996).

KOSKI (1996)

In order to attribute the ex-day price effect to taxes, researchers must reject non-

tax explanations. In past work, these rejections have lacked formal justification. Koski

examines the microstructure of trading during 1983 and 1988 using data on the Standard

and Poor's 500 companies. This period spans the U.S. tax reforms in 1984 and 1986.

Looking at bid-ask spreads allows Koski to measure the profitability of dividend-

capture trading. Koski finds that dividend-capture trading at prevailing bid-ask spreads

presented profit opportunities in 1983. However, by 1988 such opportunities had

disappeared, as dividend-capture traders could not profit given the transaction costs

reflected in the bid-ask spread. Koski notes that other researchers observed an increase in

the intensity of dividend-capture trading over this period, which is consistent with the

observed evaporation of profitable opportunities by 1988. If market micro-structure

alone can explain the ex-day effect, then nothing is left for taxes to explain.

28

FRANK AND JAGANNATHAN (1998)

Frank and Jagannathan (FJ) produce provocative results by investigating the ex-

day price behaviour of equities in Hong Kong, a country in which residents face neither

dividend nor capital gains taxation. If an ex-day effect exists in Hong Kong, then taxes

cannot be the lone cause of the effect. Using data on 351 firms from 1980 to 1993 they

report an average dividend of HK$0.12 and an average ex-day price drop of HK$0.06.

This large ex-day price effect cannot be attributable to taxes if potential dividend-capture

traders face Hong Kong taxes. Foreign dividend-capture trading on the Hong Kong

market is effectively precluded by settlement regulations and institutional details. 15 This

means that the ex-day price effect will not be determined by the tax status of foreign

traders.

FJ find that the ex-day effect can be best explained by two factors. First, like

Koski (1996), they show how the transaction cost of the bid-ask spread renders dividend-

capture trading unprofitable. Second, they find that the discrete nature of tick-sizes

contributes to the observed ex-day price effect.16 Unless the dividend is a scalar multiple

of the prevailing tick-size, then the price is prevented from adjusting by the amount of the

dividend. These factors partially explain how the ex-day price effect can occur in lightly-

taxed Hong Kong.

15 For example, regulations require the physical deli very of the stock certificate before dividends may bepaid.16 Tick size refers to the price increment used in the stock market.

29

Research on ex-day price effects has uncovered weak and circumstantial evidence

on the importance of taxes in explaining the effect. Lasfer and LH uncover some

evidence on the importance of taxes in explaining the ex-day price effect. The

subsequent work by Koski and FJ however, suggests that observed effects can be

explained by micro-structure factors like transaction costs and the tick-size. In the end,

neither view precludes the other, as the ex-day price effect could in truth be partially

explained by both tax and micro-structure factors. That non-tax factors can potentially

explain the ex-day is not the same as finding that taxes have no influence on equity

prices. Instead, it suggests only that the true tax effect on ex-day prices may be

unobservable in the presence of binding transaction costs that limit dividend-capture

trading. So, this literature provides inconclusive evidence of the degree to which taxes

affect firms’ cost of capital.

3.2 Capitalization of Capital Gains Taxes

If domestic personal taxes affect the required rate of return of the marginal

investor, this wil l be reflected in the price of equity. By analyzing equity prices

immediately following tax policy announcements, an inference about the degree to which

taxes are priced into equities can be made. Certain types of policy reforms are

inappropriate for event studies of this nature. For example, if announcements are not

credible when made or are widely anticipated in advance, the signal provided by the

announcement may be too weak to appear in equity prices. Similarly, if the tax policy

reform is bundled with other reforms or is coincident with other significant news events,

30

then separating the effect of the policy reform of interest may be impossible. The papers

discussed in this section use this natural experiment methodology to examine the impact

on equity prices of reforms to personal taxes on capital income.

McKENZIE AND THOMPSON (1995a)

The 1986 Canadian federal budget changed the way that dividends are taxed,

leading to an increase of approximately 9% in the effective tax rate on dividends. There

was no change in the taxation of capital gains, meaning that a clear prediction about the

relative valuation of stocks with different dividend payout rates can be made.17 If

personal taxes are capitalized into equity prices, then stocks with high dividend yields

should see their prices fall by more than those with low dividend yields. This hypothesis

is tested by McKenzie and Thompson (MT).

To allay concern that the change was anticipated in advance, (MT) analyze media

commentary before and after the budget. In the pre-budget period, they report no

evidence that the financial press anticipated the change to dividend taxation. After the

budget, media commentators expressed surprise about the dividend taxation

announcement. As a control for contemporaneous announcements (in the budget or from

other news sources), MT take a sample of 53 firms listed on the TSE with both preferred

and common shares trading in the market. This provides a natural control for industry, or

even firm, specific effects. The preferred shares had an average dividend yield of 9.34%,

17 Previous Canadian reforms introduced contemporaneous changes to both dividends and capital gains.This frustrates any attempt by researchers to identify the effect of the reform on different types of stocks.

31

while the common shares had an average dividend yield of 3.29%. This leads to the

prediction that the price of the preferred shares should drop more than the price of

common shares in reaction to the budget.

A problem with this natural experiment arises from other relevant announcements

contained in the 1986 budget. Most notably, the budget announced the beginning of the

implementation of revenue-neutral reforms to the corporate income tax. These reforms

were first proposed with the May, 1985 budget. The 1986 budget, while laying out in

more detail the path reform would take in the future, contained relatively little credible

news for financial markets in this area. So, while inferences about causation from the

experiment should be made with caution, the change to the taxation of dividends presents

the most probable source of relevant news in the budget.

MT compare the equity weighted mean of the abnormal return to preferred shares

with the same calculation for common shares. The difference between these two means

is negative and statistically significant, suggesting that the change in dividend taxes

affected the prices of high and low dividend stocks in the predicted way. To see if the

observed effect is caused by differences between common and preferred shares other than

the dividend yield, MT perform regressions on each group separately. Since this removes

the firm controls, they insert four industry control variables to pick up any industry

specific shocks. In these regressions, the effect is identified from the variation in the

yield within each equity class. For both common and preferred shares, the result is robust

32

to this specification for the use of a two day window, but fails for preferred shares with a

one day window.

This reform presented a relatively clean natural experiment. By using common

and preferred shares of the same set of firms, firm specific reactions are controlled for,

leading to much confidence in the results. Canadian equity prices do appear to capitalize

personal taxes, meaning that an interpretation of Canada’s situation as strictly fitting the

small open economy model cannot be supported by the evidence.

LANG AND SHACKELFORD (1999)

In May 1997, the long-term capital gains tax rate in the United States was reduced

from 28% to 20%. Lang and Shackelford (LS) interpret equity price movements

immediately following the announcement of the reform as a natural experiment to

identify the degree to which second round taxes are priced into equity valuations. Like

other studies in this literature, variation in treatment is found by using dividend yields.

Stocks with lower dividend yields wil l, ceteris paribus, be more heavily affected by a

capital gains tax cut.

In a congressional system, clean natural experiments are rare, owing to the degree

of public consultation among the different centres of power. In this case, a surprise

announcement adds credibil ity to the interpretation of this event as an experiment.

Leading up to the budget accord, public debate about the budget by Republican leaders in

33

Congress and off icials from the administration did include talk of a capital gains tax cut,

but its prospects seemed slim. This changed on the last day of April , when the

Congressional Budget Office announced a substantial $45 bill ion downward revision in

their deficit estimate, which gave policy makers much more room to maneuver. Within a

week, a budget deal containing the capital gains tax cut was announced.

LS run regressions on weekly returns, with a dummy for the first week of May

1997 intended to capture the effect of the announcement. This dummy is interacted with

the dividend yield to uncover the differential effect of the reform for stocks with different

dividend policies. LS find strong significant price effects during the week of the reform

announcement. These price effects decrease with the dividend yield, which is consistent

with the prediction. Their results are robust to a variety of specifications. While this

natural experiment may be soiled by some market anticipation of the cut, the unexpected

announcement by the Congressional Budget Office provides a credible source of surprise.

The results are large, and consistent with the hypothesis that personal taxes are

capitalized into equity prices.

These three papers present strong evidence that tax policy changes have influence

on equity prices. If this is true, then the required return of the marginal investor must be

compensated by the firm for personal taxes. We interpret this evidence to suggest that

changes to the capital gain tax could influence firms' cost of capital. Mackenzie and

Thompson (1995b) estimate that a 10 percentage point reduction in the capital gains tax

rate would result in a 3% to 6% decrease in the user cost of capital. If we consider a

34

change in the inclusion rate from 75% to 66 2/3%, this implies a 4 percentage point

decrease in the capital gains tax rate for those in the highest tax bracket.18 Using

Mackenzie and Thompson’s estimates, this would imply a decrease in firms’ cost of

capital of 1.2% to 2.4%.

To relate this to investment requires estimates of the sensitivity of investment to

changes in firms’ cost of capital. Cummins, Hassett, and Hubbard (1996) estimate this

elasticity using cross-country firm-level panel data.19 They measure the elasticity of

investment in Canada to be 0.81. This estimate is higher than those found by previous

researchers, so we will use 0.81 to derive a rough upper bound on the effect of capital

gains taxes on investment.20 Taking the elasticity of 0.81 and applying it to the range for

the change in the cost of capital derived above implies an estimate for the induced change

in investment of 1% to 2%.

18 In addition to the federal tax rate, we assume a provincial tax rate of 50%.19 The price elasticity of investment is defined as the percentage change in investment divided by thepercentage change in the user cost of capital.20 See Chirinko (1993) for a full review of the empirical literature on investment.

35

4.0 CONCLUSION

This paper has examined recent empirical evidence on the effects of capital gains

taxation on economic activity. First, evidence on the realizations elasticity suggests that

capital gains tax cuts are unlikely to be self-financing in the long-run. Second, the

balance of the evidence shows that personal taxes like the capital gains tax do affect

firms’ cost of capital. Recent empirical evidence suggests that productive investment by

firms exhibits a strong reaction to tax-induced changes to the cost of capital. This being

the case, the evidence presented here indicates that a capital gains tax cut would mean a

reduction in tax revenues, but could increase productive investment in Canada.

36

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