The Capital Gains Lock-In Effect and Earnings Quality

46 Pages Posted: 30 Dec 2019

See all articles by Stephen G. Dimmock

Stephen G. Dimmock

National University of Singapore; Asian Bureau of Finance and Economic Research (ABFER)

Fan Feng

Beihang University

Huai Zhang

Nanyang Technological University (NTU)

Date Written: December 9, 2019

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

Suggested Citation

Dimmock, Stephen G. and Feng, Fan and Zhang, Huai, The Capital Gains Lock-In Effect and Earnings Quality (December 9, 2019). Available at SSRN: https://ssrn.com/abstract=3500675 or http://dx.doi.org/10.2139/ssrn.3500675

Stephen G. Dimmock

National University of Singapore ( email )

15 Kent Ridge Drive
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Singapore

Asian Bureau of Finance and Economic Research (ABFER) ( email )

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Fan Feng

Beihang University ( email )

Xueyuan Road, Haidian District
Beijing, 100191
China

Huai Zhang (Contact Author)

Nanyang Technological University (NTU) ( email )

Nanyang Business School
50 Nanyang Ave.
Singapore, 639798
Singapore
+65-6790-4097 (Phone)

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