The Capital Gains Lock-In Effect and Earnings Quality

Abstract

The taxation of realized capital gains creates a lock-in effect, increasing an investor’s expected holding period. We show that the unrealized capital gains of mutual funds are positively associated with the earnings quality of their portfolio firms. Consistent with tax-induced lock-in, the effect of unrealized capital gains is more pronounced for mutual funds with tax-sensitive investors than for funds with tax-insensitive investors. Moreover, the positive effect of capital gains lock-in on earnings quality is stronger during periods when the capital gain tax rate is higher and for firms with highly concentrated mutual fund ownership. In sum, our findings suggest that locked-in mutual funds improve their portfolio firms’ earnings quality through more monitoring.

Keywords: Earnings Quality, Earnings Management, Capital Gains Tax, Capital Gains Lock-in, Mutual Funds

JEL Classification: M40, M41, G23, G34, H20