Capital Gain Tax Overhang and Price Pressure

Abstract

Capital gains tax can impose potentially large cost on investors selling stocks. This cost can sometimes be an order of magnitude larger than conventional transaction costs. This paper addresses the question of whether capital gains taxes serve as an impediment to selling and if so, to what degree this delayed selling by investors correspondingly affects stock prices. Using a database of large U.S. institutions' stock holdings with data on institutions' client profiles, two main results are obtained. First, selling decisions by institutions serving tax-sensitive clients are shown to be sensitive to their cumulative capital gains, which is not the case for institutions with predominantly tax-exempt clients. In particular, both the likelihood and magnitude of selling by institutions that serve taxsensitive clients are negatively related to the cumulative capital gains. Second, tax-related underselling appears to significantly impact stock prices during negative earnings announcements, for stocks held by a large number of tax-sensitive investors. Specifically, following a negative quarterly earnings surprise, tax-sensitive investors sell less aggressively a stock that has large capital gains; thus for a stock held primarily by taxsensitive investors, the corresponding price reaction is less negative if it has accumulated large capital gains. Further analysis shows that the price reaction pattern is more severe when arbitrage is more costly.

Keywords: Capital gain tax, price pressure, institutional investor, earnings announcement, limits to arbitrage

JEL Classification: G12, G14, G20, G23, H20