The Effect of Repeal of the Capital Gain Preference on Venture-Backed Companies

Abstract

The 1986 Tax Reform Act eliminated preferential tax treatment of capital gains. Proposals to reinstate the preference suggest that risky new investment will suffer without favorable treatment of investment returns. Others have argued that capital for risky new ventures is largely supplied by tax-exempt institutions, who are expected to be indifferent to the taxation of realized gains. This study evaluates the effects of the repeal of preferential capital gains taxation on venture backed firms. The results show negative abnormal returns for sample firms following the Senate’s vote to repeal the capital gain preference. The returns were more negative for firms with a high debt-to-assets ratio, suggesting a more adverse effect for firms relying on equity finance for future capital needs. Sample firms were expected to be particularly sensitive to the tax change, and the results may not be generalizable to other forms of risky investment.