Capital Gains Taxation and the Cost of Capital: Evidence from Unanticipated Cross-Border Transfers of Tax Bases

Abstract

In a cross-border takeover, the tax base associated with future capital gains is transferred from target shareholders to acquirer shareholders. Cross-country differences in capital gains tax rates enable us to estimate the discount in target valuation on account of future capital gains. The estimation suggests that a one percentage point increase in the capital gains tax rate reduces the value of equity by 0.225. The implied average effective tax rate on capital gains is 7% and it raises the cost of capital by 5.3% of its no-tax level. This indicates that capital gains taxation is a significant cost to firms when issuing new equity.