Two Papers on the Capital Gains Tax and the Stock Market

I came across two interesting papers on capital gains taxes and their effect on the stock market.

The first paper, “Capitalization of capital gains taxes: evidence from stock price reactions to the 1997 rate reduction” was published in 1999 and was written by Mark H. Lang and Douglas A. Shackelford. 

This paper uses data from 1997 to try to get to the bottom of a few different views on capital gains taxes. The three theories are as follows:

  1. When capital gains taxes are reduced, shares are more valuable to individuals and so share prices rise.  Theoretically, this effect should be larger when share repurchases or liquidation of assets are expected. It should also be larger if stock holders are likely to be individuals who are subject to capital gains taxes.
  2. Capital gains taxes only tax assets that are sold, so they create a lock in effect on current owners. A reduction of the capital gains tax diminishes this lock in effect by reducing the tax on sellers, so a reduction of the tax should drive the value of stocks down.
  3. If stocks are valued as the sum of their future dividends, or if the marginal investors are unaffected by capital gains tax rates, then changes in the capital gains tax rate shouldn’t have any effect at all.

The study found that during the week of the announced 1997 capital gains but not dividends tax cut, non-dividend paying stocks outperformed dividend paying stocks. This result is consistent with the first theory, where lower capital gains taxes increase the value of assets and vice versa.  The paper also failed to find evidence of a lock-in effect, as stocks with prior gains didn’t decline after the new capital gains tax rate went into effect.

The second paper was published in 2001 by James M. Poterba and Scott J. Weisbenner wrote “Capital Gains Tax Rules, Tax-loss Trading, and Turn-of-the-year Returns” 

This paper combines an analysis of end of the year trading anomalies with tax-loss trading. One theory is that losing trades will be sold at the end of the year in order to counter the tax implications of realized gains in other parts of the portfolio. Unfortunately, this same behavior can also be explained by “window dressing”, in which firms sell losers so their investors don’t see bad stock picks in their year end statements.  The paper attempts to distinguish the two by looking at how end of the year effects react to changes in tax laws.  A capital gains tax change would only affect individual investors while it wouldn’t affect window dressing at all, as window dressing may be done by managers for untaxed institutions as well managers for individual investors.  

The study looked at three different regimes.

Regime 1: Six month short term holding period, long term losses 100 deducible against adjusted gross income

Regime 2: Six month short term holding period, long term losses 50 deductible against adjusted gross income

Regime 3: 12 month holding period.

Stocks with losses at the start of the year exhibited less year end anomalies when 6 months was the demarcation before short term and long term holding. The paper doesn't disprove window dressing, but it does show that tax laws impact year end trading.