Discussion of Germany's Repeal of the Corporate Capital Gains Tax: The Equity Market Response

Abstract

AUTHORS’ ANALYSIS Edwards et al. (2004) address an important research question in a relatively unique setting: the taxation of corporate level capital gains tax and the extent to which those taxes cause economic inefficiencies. Inefficiencies can arise if capital gains taxes cause assets to be ‘‘locked in’’ to less than optimal uses. Although it seems obvious that ‘‘lock-in’’ occurs, the extant literature indicates that the matter is not so clear. The advent of sophisticated investment vehicles (such as Debt Exchangeable for Common Stock [DECS]; see Sheppard 1996) and clever tax planning has potentially reduced the effects of capital gains taxes, particularly for large corporations. Furthermore, little investigation of this issue has occurred outside of the United States. Three facts make the repeal of the Germany capital gains tax useful for examination. First, the German tax was particularly high (on the order of 50 percent depending on the asset being held). Second, the repeal of the tax was a surprise. Third, German equity markets are noted for their ‘‘crossholdings,’’ where one German corporation (especially banks and insurance companies) holds a substantial number of shares of other German corporations. These large crossholdings (which date back some 50 years) provide a strong tax incentive to divest long-held shares when the tax rate is reduced from 50 percent to 0 percent. Because of these factors the authors attempt to examine the equity market response to the surprise announcement of the repeal of the tax. The authors hypothesize that the repeal of the tax would cause an abnormal rise in equity prices on or around the announcement date for both those firms having substantial crossholdings and those firms that are crossheld. However, the authors’ empirical analysis seems to suggest that the German equity markets did not respond to the announcement. Further analysis finds that a few large banking and insurance companies (24 observations) did experience abnormal increases in stock prices on the event day. The authors undertake workman-like efforts to explain these odd ‘‘noresults’’ with little avail. In theory, a German company’s stock price would experience a permanent increase if its future cash flows were expected to rise as a result of the repeal of the capital gains tax. This permanent benefit could be realized if German corporations divested their holdings and those assets were allowed to rise to a higher and better economic use. There could also be a transitory stock price effect caused by the one-time benefit of selling the shares of stock free of taxation. With respect to firms that are crossheld, the issue is less clear. The