Capital Gains Tax: Implications for the Firm's Cost of Capital, Share Valuation and Investment Decision-Making

Abstract

The traditional ‘single-period' equity valuation models assume that investors’ capital gains tax liabilities can be represented as occurring annually, independently of whether or not the share is actually sold. The assumption implies that investors sell their shares on an annual basis. The essential issue as to how capital gains tax might be expected to impact on the holding decisions of shareholders, along with the likely responses of their firms, is forestalled by these models. More realistic assumptions for the imposition of capital gains tax have only recently been presented in the literature. This paper, with resource to the implications of these contributions, seeks to model the impact of capital gains tax in the functioning of equity markets, and, thereby, the impact of the tax on the equity financing and investment decisions of firms. The paper will predict that it is entirely possible that the level of capital gains taxation has only a limited impact on government revenue, while simultaneously having a disruptive impact on the workings of capital markets. We observe that high nominal levels of capital gains tax may work to increase the volatility of equity share ownership, destabilise share prices, and distort the viability of firms as ongoing concerns.