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Long-term Page 16 16 capital gains were taxed at 20%, while short-term capital gains were taxed at rates up to 50%. After the reform, no distinction was to be made between long- and short-term gains, with both being taxed at a 28% rate.

Capital Gains Taxation: Recent Empirical Evidence

Kevin Milligan, Jack Mintz, and Thomas A. Wilson University of Toronto

Prepared for The Heward Stikeman Institute September 1999


Executive Summary

This paper reviews recent empirical evidence on the economic effects of capital gains taxation. We focus on two issues. First, we examine the effects of changes in capital gains taxes on government tax revenues. The balance of the evidence suggests that while a decrease in the capital gains tax rate may lead investors to rebalance their portfolios more frequently, the increased volume of capital gains realizations will be insufficient to offset the revenue loss from the lower rate. This is especially true in Canada because of the deemed disposition of capital assets at death. For 1996, we calculate rough estimates for the federal government revenue loss in response to a reduction in the capital gains inclusion rate from 3/4 to 2/3. We find an upper bound of $400 million. If there is an increase in capital gains realizations in response to the reduction in the rate, the revenue cost would of course be lower.

Beyond the budgetary considerations, changes in capital gains taxes can have important effects on investment in the economy. We examine evidence relating to the effect of capital gains taxes on firms’ cost of capital, which plays a critical role in firms’ decisions about productive investment. Even in a world with large tax-exempt entities (such as pension funds) and some degree of international capital mobility, taxes do appear to have an impact on the cost of capital for firms. We use the results of recent research to calculate that a reduction in the inclusion rate from 3/4 to 2/3 could increase investment by as much as 2%.




The tax treatment of capital gains once again is of policy interest in Canada. Pressure for change arises from both internal and external sources. Within Canada, the fiscal surpluses projected for the imminent future present an opportunity to change the structure of taxation as the overall level of taxation is lowered. From outside Canada, recent reforms to capital gains taxes in the United States have increased the difference between the two countries’ treatment of capital gains. The taxation of capital gains raises several issues: the tax rate applied to gains, indexation of the tax base for inflation, the treatment of losses, and the lock-in effect on portfolio holdings. To better frame the policy discussion on this issue, we review in this paper recent contributions to the empirical literature on the economic effects of capital gains taxation.1

The empirical approaches used in capital gains studies have become more focused. Zodrow (1993) provides a detailed accounting of the advantages and disadvantages of different empirical approaches common in the literature. Researchers employing macrodata study aggregate statistics through time and across jurisdictions in order to learn about the economic effects of policy.

On the other hand, microdata

analysis uses data on the behaviour of individuals either in cross sections or through time. Zodrow expresses skepticism about the ability of microdata to account for unobservable, yet influential, individual-specific patterns in behaviour that may drive observed results. However, there has been a distinct movement in the direction of microdata in the


empirical literature, as noted by Slemrod (1998). A common thread through much recent work is the attempt to exploit ‘natural experiments’ that enable researchers to observe the same individuals under different policy regimes.2 This allows researchers to separate the effect of policy from traits of personality.

This paper first examines the impact of capital gains taxation on government tax revenues. This involves consideration of the sensitivity of capital gains realizations to the capital gains tax rate. Next, we describe the evidence on the effect of capital gains on firms’ cost of capital, which represents one of the major potential efficiency-enhancing effects of capital gains tax cuts. The paper concludes with a summary of the evidence.


A review of empirical evidence on capital gains taxation appeared in Zodrow (1993). This was partially updated in a subsequent article, Zodrow (1995). The present paper takes Zodrow (1993) as its point of departure, looking only at research since that time. 2 Different researchers attach different labels to this general approach. Natural experiments, quasiexperiments, event studies, and difference-in-differences methodologies are described in detail in Meyer (1995).




An active research literature has investigated the consequences of changes in capital gains tax rates on government tax revenues. In 1996, taxable capital gains in Canada amounted to $6.9 billion, only 1.4% of the total taxable income for individuals in that year. Burman and Ricoy (1997) report that taxable capital gains taxes averaged 6% of total assessed income from 1979 to 1988 in the United States. Given these numbers, the attention given to the effect of capital gains tax rates on revenues seems out of proportion to its importance in the revenue structure. This abnormal attention likely arises from the tempting possibility that rate cuts could lead to increases in revenues – the seductive appeal of the Laffer Curve. 3 If true, the ‘free lunch’ of a revenue-enhancing improvement to economic efficiency would make capital gains tax cuts a desirable policy reform.


The Laffer Curve derives its name from Arthur Laffer, who popularized the notion that cuts to tax rates may generate more than offsetting increases in the tax base, producing an increase in tax revenue.


Table 1 Capital Gains and Taxable Income, 1993-1996


Net Realizations

Taxable Income




















Net realizations refers to taxable capital gains less capital gains deductions.4 Taxable Income refers to total assessed taxable income. Percentage refers to net realizations divided by the taxable income for each year. All data from Statistics Canada (1993-1996).

Before examining the empirical evidence on the question of how revenue responds to capital gains tax cuts, it is important to understand the mechanism through which this occurs. This is particularly relevant for the case of Canada. Because Canada deems assets to be disposed at death, all unrealized gains must be realized within the


From 1985 to 1994, there was a $100,000 lifetime capital gains exemption available to all investors. Owners of shares in Canadian Controlled Private Corporations and farm property continue to have access to a $500,000 lifetime exclusion.


horizon of a lifetime


(or two6). The only way capital gains tax cuts can increase the

present value of government revenues is by raising the rate of asset turnover within the portfolio, meaning that gains would be realized more often. So, rate cuts affect revenues only to the extent that the taxes on more frequent realizations exceed the taxes that would have been collected with infrequent realizations. In this way, a large fraction of any new revenues generated by a rate cut represents a shifting of tax revenue from the future to the present, rather than a true increase in government revenues.

Mintz and Wilson (1995) explore this issue in more depth.

They develop a

methodology to calculate the present value of changes in capital gains rates under Canada’s deemed disposition tax system. Using this methodology, they estimate the revenue cost of the $100,000 lifetime capital gains exemption available to Canadian taxpayers from 1985 to 1994. The total net present value of the loss of the stream of revenue is estimated to be 4.5 billion dollars. This is much less than estimates not considering these important intertemporal issues.

Mariger (1995) simulates capital gains realizations within a framework similar to Canada’s deemed disposition at death rules. In the simulations, Mariger finds that large variations in the rate of asset turnover produce only small variation in the ratio of realized


In the United States, capital assets passed through an estate are not taxed, and have their cost basis updated to fair market value at the time of death. However, estate taxes may apply to assets transferred through an estate. 6 In Canada, assets gifted or bequeathed to a spouse are not subject to deemed realization; however, the cost basis of the asset is not increased. Certain farm properties have similar treatment when bequeathed to children.


gains to accruals. 7 The ratio ranges between 0.73 and 0.91 for asset turnover rates varying from 0.20 to 1.00 per annum. This suggests that a change in the capital gains tax rate would have to exert very strong influence on the rate of asset turnover to have even a moderate influence on the government’s intertemporal budget constraint. How strongly turnover reacts to capital gains tax rates depends crucially on the lock-in effect of taxes on portfolio choices. Accordingly, we begin by reviewing the evidence on how the lockin effect influences portfolio decisions.


Lock-in Effect

The lock-in effect has been a primary focus of capital gains research. Because an asset with a low cost basis will attract a large capital gains tax liability if the asset is disposed, investors find it optimal to stay ‘locked in’ to assets with a low cost basis. As stressed by Mariger, the strength of the lock-in effect determines the rate of asset turnover, which in turn determines how revenue responds to tax rates. If there is no lockin effect, changes in capital gains tax rates will serve to reduce revenue both at present and in the future. Below we examine two studies of the influence of the lock-in effect on economic decisions.


Landsman and Shackelford (LS) confirm the existence of lock-in effects by 7

In his model, the maximal tax base would be the annual accrued capital gain. Comparing actual realizations to this maximal tax base shows the proportion of the potential tax base that is captured by the


studying a particular firm through a unique circumstance.

In 1988, RJR Nabisco

underwent a leveraged buyout by its management. Through their direct access to detailed shareholder records, LS are able to measure the cost basis of each shareholder's holdings. This information is used to test hypotheses related to the lock-in effect.

LS report two key findings. First, the cost basis of the shares played a role in determining a shareholder’s choice among the options offered by the buy-out group. One option offered strictly cash, meaning that shares were subjected to immediate taxation. Another option offered preferred shares and debt in exchange for outstanding shares. This enjoyed a more favourable tax treatment, as capital gains could be deferred. The average cost basis of those choosing the exchange option was $19, compared to $49 for those taking cash. This is consistent with the hypothesis that those with a lower cost basis should prefer the tax-favoured option.

The second finding relates to the selling price

required by investors holding shares with different cost bases. During the period from the time the offer was announced until the day the offer closed, LS find a negative relationship between the cost basis of shares sold on a particular day and the day's price. In other words, those holding shares with low cost bases were more likely to realize their gains on days when the price was high. This suggests that those with the largest accrued gains (i.e. with the lowest cost bases) may have had systematically higher minimum selling prices in order to compensate them for their larger capital gains liability.



REESE (1998)

Without special access to shareholders’ records, it is very difficult to observe the cost basis for shares sold in the market, rendering empirical study of the lock-in effect difficult. Reese finds a novel way to measure the cost basis of asset holdings by studying initial public offerings (IPOs). For IPOs, both the date and initial cost of the stock is known. Reese exploits this feature of IPOs in order to measure the importance of the lock-in effect for the realization decision.

Before the Tax Reform Act of 1986 (TRA86), long-term capital gains (realized gains on assets held longer than one year) qualified for favourable tax treatment relative to short-term gains.

This provided an incentive for taxable shareholders to delay

realizations for stocks that had appreciated, but to speed up realizations for stocks that had depreciated. Reese tests these hypotheses using data on 968 IPOs from 1976 to 1986, and 1140 IPOs from 1989-1995. Since the favourable capital gains tax rate on long term gains disappeared after TRA86, comparing results from the two datasets will help isolate the effect of the tax provisions.

Reese finds that trading volume on stocks that had appreciated one year after the IPO increased by approximately 10% during the week following qualification for the long-term rate. Trading volume for stocks with losses after one year was significantly higher in the week preceding qualification for the long-term rate. Reese repeats the analysis for the period surrounding qualification using returns. The results are similar.


There was a significantly lower abnormal return to appreciated stocks in the week following qualification, and for depreciated stocks in the week preceding qualification. This is consistent with his hypothesis that tax considerations motivated the timing of the selling of these shares. Shares with losses were sold while still eligible for the larger deduction available with the short-term rate, while shares with gains were not sold until the long-term rate applied.

Importantly, all the above effects disappeared with the

removal of the differential long-term rate after TRA86.

JOG (1995)

Jog examines Canadian evidence of the impact of the lock-in effect by studying the introduction of the lifetime capital gains exemption in 1985. This exemption allowed $100,000 of capital gains to be realized without being taxed.8 Using aggregate taxpayer data, Jog documents an increase in total realizations, the proportion of taxfilers reporting capital gains, and the proportion of taxfilers with dividend income. During the same time period, no similar trends emerge in the United States. Jog interprets these data as being consistent with an ‘unlocking’ of accrued capital gains and an increase in stock market participation. Jog is careful about making claims of causation about the observed trends and the introduction of the lifetime capital gains exemption. Because he is unable to control for other factors that may be influencing his data, his caution is justified. Still, this data provides some evidence that the lock-in effect does influence portfolio choice in Canada.


The limit was originally $500,000. There were also changes in the assets qualified to be included in the exemption during through the years it existed. The details can be found in Jog (1995).


On the whole, this evidence strongly suggests that capital gains taxes can affect portfolio and realization decisions. Is the strength of this effect sufficient to allow capital gains tax cuts to generate higher tax revenues? We now address this question.


Revenue Effects

The question of how government revenue responds to capital gains tax changes has been the subject of a large literature. These studies focus on the responsiveness of capital gains realizations with respect to changes in the capital gains tax rate – the elasticity of realizations. The elasticity of realizations is defined as the percentage increase in the tax base divided by the percentage reduction in the tax rate. Tax revenues will rise (fall) if the percentage increase in the base induced by the rate reduction is greater (less) than the percentage decrease in the rate. Thus, if the elasticity is more (less) than one, a decrease in the rate will increase (decrease) revenues. For this reason, most studies focus on the comparison of estimated elasticities to one.

There are a number of reasons why a simple comparison of estimated elasticities to one may be misleading. Gillingham and Greenlees (1992) emphasize that with a progressive income tax, realizations may push taxpayers into a higher tax bracket. If this is the case, then an elasticity lower than one may be sufficient to bring about a revenue neutral rate cut. The lack of progressivity in the Canadian income tax at high income


levels may diminish the impact of this argument in Canada.9 Gravelle (1995) points out the importance of revenue feedback effects. For example, lower capital gains taxes might change corporate distribution policies. This would have impact on taxes collected from dividend payments. Accounting for these types of induced tax effects complicates the interpretation of the realizations elasticity. Below, we examine three recent empirical studies of capital gains realizations.

At the time of Zodrow (1993), drawing clear

conclusions from the available evidence was difficult. This is no longer the case, as new results have laid the groundwork for consensus on this question.


This landmark study reconciled the seemingly disparate results of previous research. As noted by Zodrow, past studies using aggregate macrodata tended to find realization elasticities closer to zero than one, while those using microdata found realizations to be much more responsive to capital gains tax rates.

Burman and

Randolph’s innovation was to empirically identify separate temporary and permanent responses to changes in capital gains tax rates. With a progressive income tax and income varying from year to year, realizing capital gains in low income years allows for some degree of tax base smoothing. By ignoring this possibility, previous studies using microdata overstated the sensitivity of realizations to tax changes.


In 1996, 64% of the total dollar value of capital gains realizations were made by taxpayers with over $100,000 in income. The income tax is strictly proportional in this range for taxpayers from any province.


A problem common to all microdata studies of realizations behaviour is properly measuring the effect of the marginal tax rate. Realizations affect the marginal tax rate, while the marginal tax rate may also influence realizations. This feedback effect imperils inferences from standard econometric techniques. To overcome this endogenous variable problem, Burman and Randolph (BR) use an instrumental variables estimator. For the permanent tax rate, they use the applicable top statutory combined state and federal rate on capital gains as an instrument. This is unlikely to be correlated with individual transitory income shocks, but will be correlated with the individual’s tax rate.


of this, the top combined rate can be used to uncover an unbiased estimate of the effect of taxes on realizations. However, if the state of residence decision depends on capital gains tax rates, this instrument may be problematic. 10 BR also require an instrument for the transitory marginal tax rate faced by the individual.

The marginal tax rate on the last

dollar of other income (excluding capital gains) serves this purpose.11 This tax rate will be correlated with the true marginal tax rate facing the individual, but will not depend on capital gains realizations.

Armed with these instruments, they estimate a two-step regression on a panel of approximately 11,000 taxpayers through the years 1979 to 1983. The first stage of the regression predicts whether or not an individual will realize any capital gains, given individual characteristics and the predicted tax rates. The results from this regression are


The potential endogeneity of the state residence decision with capital gains tax rates is discussed in more detail below in reference to the study by Bogart and Gentry (1995). 11 Triest (1998) discusses methodological concerns with the use of first-dollar marginal tax rates as instruments.


used in the second stage in order to estimate the magnitude of capital gains that are realized.

The results are striking. The point estimate of the permanent realization elasticity is 0.18, with a standard error of 0.48. This is indistinguishable from zero. However, the point estimate for the transitory elasticity is 6.42, with a standard error of 0.34. This is much larger than found in previous studies. When the permanent marginal tax rate is omitted from the specification, the estimate for the transitory marginal tax rate becomes 4.19.

This estimate is closer to the results found in previous microdata studies,

suggesting that the omission of the permanent tax rate caused previous studies to underestimate the short-run sensitivity of realizations to the tax rate.

The instruments in this study are imperfect and the panel is short. Notwithstanding these faults, this paper does much to reconcile the debate about capital gains realizations elasticities. This evidence suggests that while capital gains realizations are very sensitive to rates in the short run, the long run sensitivity may be quite small.


The Tax Reform Act of 1986 (TRA86) presented a natural experiment to tax researchers.

Burman, Clausing, and O'Hare (BCO) exploit this reform to examine

transitory capital gains realizations. Before the reform, the tax rate applicable to capital gains realizations depended on the length of time the asset had been held. Long-term


capital gains were taxed at 20%, while short-term capital gains were taxed at rates up to 50%. After the reform, no distinction was to be made between long- and short-term gains, with both being taxed at a 28% rate.

If TRA86 had arrived in the form of a surprise decree from the tax authority, identifying the effect of the reform on realization behaviour would have been much simpler. However, in a congressional system with many centres of power, the journey of TRA86 into law was full of twists. From the original proposal by the U.S. Treasury Department in 1984 to its signing by President Reagan in October of 1986, it went through many changes in content, and its eventual implementation was never certain.

BCO develop a model to explain how realizations of short- and long-run gains and losses should react to the announcement. They test the implications of their model on a panel of taxpayers. In the panel are taxpayers who sold capital assets, with rich data on the sale price, cost basis, and asset class.

BCO include dummy variables for weeks following various important milestones in the legislative path followed by TRA86. This facilitates the isolation of the effect of these announcements on realizations from other influential factors, such as the ebbs and flows of the stock market. TRA86 proposed an increase in the rate on long-term gains, while the rate on short-term gains was to drop. For an investor wishing to minimize taxes, losses should be realized when rates are higher and gains when rates are lower. Consistent with this model, BCO find that as the final form of TRA86 took shape,


realizations of long-term gains and short-term losses accelerated, while realizations of short-term gains dropped. The behaviour of long-term loss realizations did not show any reaction to the legislative announcements.

Following their regression analysis, they present aggregated net realizations for different types of taxpayers and different asset classes through the time period of the reform. This aggregate data is strongly consistent with their model. For example, the dollar value of long-term capital gains realizations of corporate stock in December 1986 was seven times the level of the previous December. This suggests that taxpayers with unrealized long-term gains preferred to realize them at 20%, rather than face the higher long-term rate in the future.

Trying to capture announcement effects and changes in expectations is always difficult because of problems separating the desired effects from contemporaneous shocks. Although BCO control for current and lagged macroeconomic variables, investors’ expectations about crucial future variables are not available. This complicates interpretation of their regression evidence, which on its own, is not completely convincing.

However, the evidence in the aggregated data bolsters their argument.

Given these patterns of realizations through this period of reform in 1986, it seems a safe conclusion that future capital gains tax rates can have a substantial effect on realizations behaviour.

This provides further evidence about the importance of distinguishing

between transitory and long term revenue impacts when discussing capital gains realizations elasticities.



Bogart and Gentry (BG) take a fresh approach to the use of macrodata to estimate the realizations elasticity. Previous macrodata studies received criticism for making inferences from small datasets that included very little variation in the tax rate. BG overcome these two problems by disaggregating realizations data to the state level. Looking at 51 jurisdictions within the U.S. over 12 years provides a much larger sample size. Equally important, there is much variation both across states and through time in the capital gains tax rate. This variation allows for greater confidence in the results.

Using interstate variation to identify the realizations elasticity requires that capital gains decisions be independent of state residence decisions. BG assert that factors other than capital gains tax rates weigh much more heavily in the state residence decision. This does seem plausible, but it is insufficient. If a state’s capital gains tax rate is correlated with some excluded variable that does exert influence on the state residence decision, then BG’s assumption of exogeneity fails. An excluded variable that fits this description might be a state’s overall level of taxation. Capital gains tax rates are not likely to be randomly distributed across states, but instead may be correlated with a state’s overall tax level. For the interstate variation in capital gains tax rates to be exogenous in this case, the state residence decision must be independent of the overall tax stance of the jurisdiction. This may be true, but it is a stronger condition than what BG discuss.


BG estimate different specifications to try and control for heteroskedasticity, and to see the effect on their results of the inclusion of future and past tax rates. Their preferred specification (including random year effects) produces an estimated capital gains realization elasticity of 0.645. A 95% confidence interval around this estimate does not include one. This result is strongly robust to different error structures and the inclusion of past and future tax rates, with other estimates ranging from 0.633 to 0.686. When some years are excluded, or state effects are introduced, the result appears much less robust. This is not surprising, as the smaller time periods exclude much of the time variation in rates, and the inclusion of state effects weakens the ability of interstate variation to identify the elasticity.

The methodology employed by BG represents a

substantial improvement on previous macrodata studies. Their results empirically bound the realizations elasticity away from one, and this result is convincingly robust.



The literature on capital gains realizations has matured. The work by BR and BCO emphasizes the crucial importance of separating short-run from long-run effects. The methodology of BG succeeds in extracting as much as may be possible from a macrodata analysis. This evidence convincingly bounds the long run elasticity higher to be less than one. In addition, Mariger’s simulations provide an important caveat for countries in which capital gains must be realized at death – any increases in current revenue will decrease future government revenue. Overall, from the available evidence,


a claim that capital gains tax cuts will be self-financing in the long run cannot be supported empirically.

The results of the research discussed in this section can be used to obtain a rough estimate of the revenue cost of a particular policy reform. In 1996, net taxable capital gains realizations by individuals were $6.6 billion. Based on Finance Canada’s Tax Expenditure estimates, net federal revenues for personal capital gains taxes were about $2.0 billion. Taxable capital gains realized by corporations generated an additional $1.8 billion of federal revenue.12 Now consider a cut in the capital gains inclusion rate from 75% to 66 2/3%. With no change in realizations, this would cause a drop in federal revenues of about $0.4 billion. However, if realizations increase as a result of the lower tax rate, then the increase in tax base would partially offset the drop in the tax rate, leading to a smaller net revenue loss. From the American studies discussed above, an elasticity of 0.5 seems a reasonable upper bound on the long run elasticity, although the short run elasticity could be much larger, possibly greater than one. However, as mentioned earlier, Mintz and Wilson (1995) indicate that results from American studies have only limited application to the Canadian case because of the differing treatment of capital gains at death.13 Also, any reduction in capital gains taxes paid by corporations should generate a partial offset through increased income taxes on dividends and/or capital gains at the


See Finance Canada, Tax Expenditures 1999, Tables 1 and 2. With deemed disposition at death, part of the increase in tax base represents realizations that are shifted from a future year to the current year, rather than a true increase in lifetime realizations. Furthermore, none of the studies reviewed dealt with realizations of capital gains by corporations. 13


personal level. Making some allowance for both of these factors would reduce the revenue cost of this tax change to about $0.3 billion.




One important channel through which capital gains taxation influences economic efficiency is the effect on firms' cost of capital. If the cost of capital paid by a firm decreases, then the firm will undertake more investment projects.

With increased

investment comes higher living standards and better employment. In this way, capital gains taxes can be linked very directly to tangible measures of welfare.

Capital gains taxes influence a firm’s cost of capital by changing the rate of return required by the marginal investor in the firm's equity. If taxes change the required return, then the price the marginal investor is willing to pay for a share of the future stream of the firm's earnings will change.

Because of this, the capital gains tax would be

capitalized into the price of the share.

If personal taxes on the firm’s income are

increased (decreased), the price of the share falls (rises). So, the response of equity prices provides direct evidence of how firms' cost of capital changes with capital gains tax rates.

If Canadian markets are small relative to the world, and if capital may flow freely across borders, then the return required by the marginal investor will be determined by world market conditions outside the influence of Canadian tax policy. This implies that domestic capital gains taxes would have no impact on required rates of return. This ‘tax irrelevance’ view, associated closely with Miller and Scholes (1982), holds if the marginal investor is, for example, a tax-exempt entity like a pension fund, an investor from abroad not subject to domestic taxes, or anyone facing the same effective rate of


taxation on dividends and capital gains. This section will examine evidence of the impact of domestic taxes on equity prices in order to infer the role of capital gains taxes in determining firms' cost of capital. 14 If taxes do not affect equity prices, then changes in capital gains tax rates will have no influence on firms’ cost of capital, and so no effect on investment. However, if taxes do have a large effect on equity prices, then changes in capital gains tax rates will change firms’ investment decisions.


Ex-day price effect

Researchers have identified an intriguing experimental setting in which to examine the influence of domestic personal taxes on equity prices. Typically, firms announce the size and the date of a dividend in advance. The day before dividends are paid (referred to as the cum-dividend day), a purchaser of a share will be entitled to the dividend. A purchaser of the share after the day the dividend becomes payable (the exdividend day), will not receive the dividend.

In a frictionless capital market without taxes, one expects to see the price of the share drop on ex-day by exactly the amount of the dividend. If this were not the case, a trader following a dividend capture strategy could profit. Such trading would take the following form. A trader buys the stock cum-dividend at the prevailing market ask price, 14

A large literature examines the role of dividend taxes on firms’ cost of capital. Zodrow (1991), McKenzie and Thompson (1996), and Head (1997) review this literature, each with a different focus. Boadway and Bruce (1992) argue theoretically that integration of corporate and personal taxation is irrelevant in a small open economy. Devereux and Freeman (1995) provide empirical evidence suggesting dividend taxes do matter. McKenzie and Thompson (1996) come to the same conclusion in their review of the empirical literature on this question.


holds the stock long enough to earn the dividend, then sells it ex-dividend at the prevailing bid price.

So, in the absence of profitable dividend capture trading

opportunities, the price of the share should drop by exactly the amount of the dividend on ex-day. Elton and Gruber (1970) documented empirically that this was not the case – prices dropped by less than the amount of the dividend on ex-day. This spawned a literature attempting to document the magnitude of the ex-day effect, and to separate competing hypotheses explaining its presence.

The tax explanation for the ex-day effect is related to the relative tax treatment of dividends and capital gains. If dividend-capture traders are subject to taxation, the noarbitrage condition becomes

D(1 − τ div ) = (Pc − Px )(1 − τ cg ) ,

where D is the magnitude of the dividend, Pc and Px denote the cum-dividend and exdividend prices, and τdiv and τcg represent the effective tax rate on dividends and capital gains. Rearranging this leads to

(Pc − Px ) = (1 − τ div ) . D

(1 − τ ) cg

From this expression it is clear that a price drop of less than the dividend could reflect a lower effective tax rate on capital gains than on dividends.


LASFER (1996)

This paper examines British data on the ex-day price effect. It looks at 108 industrial and commercial companies between 1979 and 1983, a period in which dividends were taxed heavily relative to capital gains. First, Lasfer establishes the existence of an ex-day price effect. The firms exhibited an average excess pre-tax return on ex-day of 1.90%, which is significantly different from zero. Because there are no significant excess returns on days preceding or following ex-day, the author suggests that tax considerations are the most likely cause.

The absence of policy reforms over the period under consideration weakens the credibility of the attribution of the ex-day effect to taxes. Common with earlier efforts in this literature, the approach taken to identify taxation as the cause of the ex-day effect is to rule out other potential explanations, leaving taxes as the residual explanation. This approach is not fully convincing.

A further test is applied to the excess returns using information on dividend yields. If the excess return is explained by dividend taxes, then stocks with higher dividend yields should exhibit stronger excess returns on ex-day, since the higher taxed dividends figure more prominently in the firm's distributions.

The excess return is

regressed on the dividend yield and a measure of the firm's size, uncovering a strong, positive effect. However, if high dividend yield firms differ from low dividend yield


firms in ways that are correlated with the ex-day excess return, then the failure to control for these other factors would bias the coefficient on the dividend yield. The absence of these controls leaves unknown the robustness of this result. Still, this regression provides evidence that is consistent with taxes explaining some part of the ex-day price effect.


Lamdin and Hiemstra (LH) exploit TRA86 to identify the effect of personal taxes on the ex-day price effect. The tax reform dropped the top tax rate on dividends from 50% to 28%, while capital gains taxes on long-run gains increased from 20% to 28%. Because the taxation of dividends relative to capital gains dropped unambiguously, the tax hypothesis predicts that the ex-day price effect should be smaller after TRA86.

LH use a large sample of firms from the CRSP database over the period 1982 to 1991. They focus on the ratio of the price change to the amount of the dividend. The mean of this ratio increases from 0.885 in 1982-1986 to 0.918 in 1987 to 1991. The tstatistic for the hypothesis that the difference in these means equals zero is 2.06. So, this suggests that TRA86 had a significant effect on the ratio of the price change to the dividend, consistent with the predictions of the tax explanation for the ex-day effect.

While the change in the ratio is certainly consistent with the tax explanation, other factors could be underlying the observed result. The authors discuss and reject other possibilities for this change in the ratio. For example, any change in transaction costs,


risk, or other non-tax factors during this period could have affected the willingness of investors to undertake dividend capture trading. Their rejection of other explanations may be unsupportable, however, given the evidence provided by Koski (1996).

KOSKI (1996)

In order to attribute the ex-day price effect to taxes, researchers must reject nontax explanations. In past work, these rejections have lacked formal justification. Koski examines the microstructure of trading during 1983 and 1988 using data on the Standard and Poor's 500 companies. This period spans the U.S. tax reforms in 1984 and 1986.

Looking at bid-ask spreads allows Koski to measure the profitability of dividendcapture trading. Koski finds that dividend-capture trading at prevailing bid-ask spreads presented profit opportunities in 1983.

However, by 1988 such opportunities had

disappeared, as dividend-capture traders could not profit given the transaction costs reflected in the bid-ask spread. Koski notes that other researchers observed an increase in the intensity of dividend-capture trading over this period, which is consistent with the observed evaporation of profitable opportunities by 1988.

If market micro-structure

alone can explain the ex-day effect, then nothing is left for taxes to explain.



Frank and Jagannathan (FJ) produce provocative results by investigating the exday price behaviour of equities in Hong Kong, a country in which residents face neither dividend nor capital gains taxation. If an ex-day effect exists in Hong Kong, then taxes cannot be the lone cause of the effect. Using data on 351 firms from 1980 to 1993 they report an average dividend of HK$0.12 and an average ex-day price drop of HK$0.06. This large ex-day price effect cannot be attributable to taxes if potential dividend-capture traders face Hong Kong taxes. Foreign dividend-capture trading on the Hong Kong market is effectively precluded by settlement regulations and institutional details. 15 This means that the ex-day price effect will not be determined by the tax status of foreign traders.

FJ find that the ex-day effect can be best explained by two factors. First, like Koski (1996), they show how the transaction cost of the bid-ask spread renders dividendcapture trading unprofitable. Second, they find that the discrete nature of tick-sizes contributes to the observed ex-day price effect.16 Unless the dividend is a scalar multiple of the prevailing tick-size, then the price is prevented from adjusting by the amount of the dividend. These factors partially explain how the ex-day price effect can occur in lightlytaxed Hong Kong.


For example, regulations require the physical delivery of the stock certificate before dividends may be paid. 16 Tick size refers to the price increment used in the stock market.


Research on ex-day price effects has uncovered weak and circumstantial evidence on the importance of taxes in explaining the effect.

Lasfer and LH uncover some

evidence on the importance of taxes in explaining the ex-day price effect.


subsequent work by Koski and FJ however, suggests that observed effects can be explained by micro-structure factors like transaction costs and the tick-size. In the end, neither view precludes the other, as the ex-day price effect could in truth be partially explained by both tax and micro-structure factors. That non-tax factors can potentially explain the ex-day is not the same as finding that taxes have no influence on equity prices.

Instead, it suggests only that the true tax effect on ex-day prices may be

unobservable in the presence of binding transaction costs that limit dividend-capture trading. So, this literature provides inconclusive evidence of the degree to which taxes affect firms’ cost of capital.


Capitalization of Capital Gains Taxes

If domestic personal taxes affect the required rate of return of the marginal investor, this will be reflected in the price of equity.

By analyzing equity prices

immediately following tax policy announcements, an inference about the degree to which taxes are priced into equities can be made.

Certain types of policy reforms are

inappropriate for event studies of this nature. For example, if announcements are not credible when made or are widely anticipated in advance, the signal provided by the announcement may be too weak to appear in equity prices. Similarly, if the tax policy reform is bundled with other reforms or is coincident with other significant news events,


then separating the effect of the policy reform of interest may be impossible. The papers discussed in this section use this natural experiment methodology to examine the impact on equity prices of reforms to personal taxes on capital income.


The 1986 Canadian federal budget changed the way that dividends are taxed, leading to an increase of approximately 9% in the effective tax rate on dividends. There was no change in the taxation of capital gains, meaning that a clear prediction about the relative valuation of stocks with different dividend payout rates can be made. 17 If personal taxes are capitalized into equity prices, then stocks with high dividend yields should see their prices fall by more than those with low dividend yields. This hypothesis is tested by McKenzie and Thompson (MT).

To allay concern that the change was anticipated in advance, (MT) analyze media commentary before and after the budget.

In the pre-budget period, they report no

evidence that the financial press anticipated the change to dividend taxation. After the budget, media commentators expressed surprise about the dividend taxation announcement. As a control for contemporaneous announcements (in the budget or from other news sources), MT take a sample of 53 firms listed on the TSE with both preferred and common shares trading in the market. This provides a natural control for industry, or even firm, specific effects. The preferred shares had an average dividend yield of 9.34%,


Previous Canadian reforms introduced contemporaneous changes to both dividends and capital gains. This frustrates any attempt by researchers to identify the effect of the reform on different types of stocks.


while the common shares had an average dividend yield of 3.29%. This leads to the prediction that the price of the preferred shares should drop more than the price of common shares in reaction to the budget.

A problem with this natural experiment arises from other relevant announcements contained in the 1986 budget. Most notably, the budget announced the beginning of the implementation of revenue-neutral reforms to the corporate income tax. These reforms were first proposed with the May, 1985 budget. The 1986 budget, while laying out in more detail the path reform would take in the future, contained relatively little credible news for financial markets in this area. So, while inferences about causation from the experiment should be made with caution, the change to the taxation of dividends presents the most probable source of relevant news in the budget.

MT compare the equity weighted mean of the abnormal return to preferred shares with the same calculation for common shares. The difference between these two means is negative and statistically significant, suggesting that the change in dividend taxes affected the prices of high and low dividend stocks in the predicted way.

To see if the

observed effect is caused by differences between common and preferred shares other than the dividend yield, MT perform regressions on each group separately. Since this removes the firm controls, they insert four industry control variables to pick up any industry specific shocks. In these regressions, the effect is identified from the variation in the yield within each equity class. For both common and preferred shares, the result is robust


to this specification for the use of a two day window, but fails for preferred shares with a one day window.

This reform presented a relatively clean natural experiment. By using common and preferred shares of the same set of firms, firm specific reactions are controlled for, leading to much confidence in the results. Canadian equity prices do appear to capitalize personal taxes, meaning that an interpretation of Canada’s situation as strictly fitting the small open economy model cannot be supported by the evidence.


In May 1997, the long-term capital gains tax rate in the United States was reduced from 28% to 20%.

Lang and Shackelford (LS) interpret equity price movements

immediately following the announcement of the reform as a natural experiment to identify the degree to which second round taxes are priced into equity valuations. Like other studies in this literature, variation in treatment is found by using dividend yields. Stocks with lower dividend yields will, ceteris paribus, be more heavily affected by a capital gains tax cut.

In a congressional system, clean natural experiments are rare, owing to the degree of public consultation among the different centres of power. In this case, a surprise announcement adds credibility to the interpretation of this event as an experiment. Leading up to the budget accord, public debate about the budget by Republican leaders in


Congress and officials from the administration did include talk of a capital gains tax cut, but its prospects seemed slim.

This changed on the last day of April, when the

Congressional Budget Office announced a substantial $45 billion downward revision in their deficit estimate, which gave policy makers much more room to maneuver. Within a week, a budget deal containing the capital gains tax cut was announced.

LS run regressions on weekly returns, with a dummy for the first week of May 1997 intended to capture the effect of the announcement. This dummy is interacted with the dividend yield to uncover the differential effect of the reform for stocks with different dividend policies. LS find strong significant price effects during the week of the reform announcement. These price effects decrease with the dividend yield, which is consistent with the prediction. Their results are robust to a variety of specifications. While this natural experiment may be soiled by some market anticipation of the cut, the unexpected announcement by the Congressional Budget Office provides a credible source of surprise. The results are large, and consistent with the hypothesis that personal taxes are capitalized into equity prices.

These three papers present strong evidence that tax policy changes have influence on equity prices. If this is true, then the required return of the marginal investor must be compensated by the firm for personal taxes. We interpret this evidence to suggest that changes to the capital gain tax could influence firms' cost of capital. Mackenzie and Thompson (1995b) estimate that a 10 percentage point reduction in the capital gains tax rate would result in a 3% to 6% decrease in the user cost of capital. If we consider a


change in the inclusion rate from 75% to 66 2/3%, this implies a 4 percentage point decrease in the capital gains tax rate for those in the highest tax bracket.18


Mackenzie and Thompson’s estimates, this would imply a decrease in firms’ cost of capital of 1.2% to 2.4%. To relate this to investment requires estimates of the sensitivity of investment to changes in firms’ cost of capital. Cummins, Hassett, and Hubbard (1996) estimate this elasticity using cross-country firm-level panel data.19 They measure the elasticity of investment in Canada to be 0.81. This estimate is higher than those found by previous researchers, so we will use 0.81 to derive a rough upper bound on the effect of capital gains taxes on investment.20 Taking the elasticity of 0.81 and applying it to the range for the change in the cost of capital derived above implies an estimate for the induced change in investment of 1% to 2%.


In addition to the federal tax rate, we assume a provincial tax rate of 50%. The price elasticity of investment is defined as the percentage change in investment divided by the percentage change in the user cost of capital. 20 See Chirinko (1993) for a full review of the empirical literature on investment. 19




This paper has examined recent empirical evidence on the effects of capital gains taxation on economic activity. First, evidence on the realizations elasticity suggests that capital gains tax cuts are unlikely to be self-financing in the long-run. Second, the balance of the evidence shows that personal taxes like the capital gains tax do affect firms’ cost of capital. Recent empirical evidence suggests that productive investment by firms exhibits a strong reaction to tax-induced changes to the cost of capital. This being the case, the evidence presented here indicates that a capital gains tax cut would mean a reduction in tax revenues, but could increase productive investment in Canada.



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