Capital Gains Taxes and the Risk-Return Tradeoff

Abstract

We derive cross-sectional implications of a capital gains tax rate change on the risk-return tradeoff on stock investment and show that stocks with higher accrued capital gains experience a larger risk-return tradeoff improvement after a capital gains tax rate cut. Stocks with higher dividend yields experience a larger increase (decrease) in the risk-return tradeoff when the dividend tax penalty effect dominates (is dominated by) the effect of reduced dividend yield associated with the capital gains tax cut. Studying both the Tax Relief Act of 1997 and the Revenue Act of 1978, we find stocks with higher accrued capital gains experienced larger increases in the expected return, the systematic risk, and the risk-return tradeoff after the capital gains tax cut. Stocks with higher dividend yields experienced larger decreases in the risk-return tradeoff, suggesting that the reduction in dividend yield associated with the capital gains tax cut may have dominated the dividend tax penalty effect.