Discussion of The Effect of the Expected Holding Period on the Market Reaction to a Decline in the Capital Gains Tax Rate

Abstract

Liang et al. (2002) (hereafter LMM) investigate cross-sectional differences in the stock market reaction to the 1997 capital gains tax rate reduction. Based on tax capitalization theory that predicts stock prices should reflect investor-level capital gains taxes, LMM hypothesize that dividend-paying stocks and stocks with a longer expected holding period have a less positive reaction to the surprise announcement of the rate reduction. LMM also hypothesize that as a stock’s expected holding period increases, the negative effect of dividend-paying status weakens, i.e., the difference in the reaction between dividend-paying and non-dividend-paying firms decreases. The holding period hypotheses are based on the argument that the longer a stock’s average expected holding period, the lesser the present value of the benefit resulting from the rate reduction. LMM present evidence consistent with these hypotheses and interpret their findings as support for tax capitalization theory. LMM’s incremental contribution is their finding that a stock’s expected holding period affects share value. LMM addresses an interesting topic using an event study methodology. This methodology, which can only be used effectively because of the surprise nature of the 1997 capital gains tax rate reduction, avoids potential problems associated with price level studies such as spurious scale effects and potential correlated omitted variables bias.