Capital Gains Taxes and Asset Prices: Capitalization or Lock-In?
University of Texas at Dallas - School of Management
Edward L. Maydew
University of North Carolina at Chapel Hill - Accounting Area
Harold H. Zhang
University of Texas at Dallas - Naveen Jindal School of Management; China Academy of Financial Research (CAFR)
Douglas A. Shackelford
University of North Carolina at Chapel Hill; National Bureau of Economic Research (NBER); University of North Carolina (UNC) at Chapel Hill - Accounting Area
February 16, 2006
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 buyers' and sellers' 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. Non-dividend 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 individual ownership exhibit lower average returns during the week the lock-in effect dominates. We also find that the tax cut increases the trading volume in non-dividend paying stocks during the dominant capitalization week and in stocks with large embedded capital gains and high individual ownership during the dominant lock-in week.
Number of Pages in PDF File: 44
Keywords: Asset pricing, capital gain taxes, capitalization, lock-in effect, Taxpayer Relief Act of 1997
JEL Classification: G12, G35, H24, D12, K34, G18working papers series
Date posted: February 28, 2006
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