Stock Market Reaction to Capital Gains Tax Changes: Empirical Evidence from the 1997 and 1998 Tax Acts

Abstract

This paper analyzes the impact of changes in capital gains taxes on equity values. Seven necessary conditions are outlined for stock prices to be affected by a change in the taxation of long-term capital gains. Specifically, the marginal investor must be an individual, investing for the requisite holding period, selling in a taxable disposition, and compliant. His short-term capital gains from all investments equal or exceed short-term capital losses, and his long-term capital gains from all investments equal or exceed long-term capital losses. In addition, the capital gains tax change must alter the investor's expectation of the taxes that will be generated when he sells in the future, and inelasticities in the supply of capital must prevent immediate economic readjustment. The paper then reviews four studies that estimate the stock market reaction to capital gains tax changes in the Taxpayer Relief Act of 1997 and the Internal Revenue Service Restructuring and Reform Act of 1998. The recency of these legislative changes and the conditions under which they were enacted provide useful settings for recalibrating the relation between stock prices and capital gains taxation. Although evaluating different firms and event periods, the studies generally find: • Stock prices react to changes in the capital gains tax policy. • Stock prices react quickly to information about tax legislation. • The stock price reaction is largely complete by public announcement of the change. • The magnitude of the stock price reaction is material. These findings join a growing literature documenting that capital gains tax policy plays a role in establishing equity values.