Download Capital Gains Tax

Capital Gains Tax
Stock Market Distortion and
Implications for Fiscal Policy
O. Mikhail
ECO 6226
Summer 2006
Jon Thorpe
What is the Capital Gains Tax?
• The tax paid on appreciated assets that
are sold for a profit by individuals
• Long term gains – those held more than a
year – receive preferential treatment
Current Rates
Jobs and Growth Reconciliation Act of 2003
Effective May 6, 2003
Tax Bracket
Short Term
Long Term
10%
10%
5%
15%
15%
5%
25%
25%
15%
28%
28%
15%
33%
33%
15%
35%
35%
15%
Stock Market Distortion
• The “Lock-In Effect”
• Investors hold their appreciated assets to
qualify for preferential long-term treatment
or to avoid the tax altogether
• The supply of shares available for
purchase decreases – not the total supply
of outstanding shares
Stock Market Distortion
• The “Capitalization Effect”
• Potential buyers require a lower price at
every trading level to offset the impact of
the tax on their expected gains
• The demand for shares decreases
Stock Market Distortion
• Combined results of the “lock-in effect”
and the “capitalization effect” in the stock
market are:
• Lower trading volume – decreased liquidity
• Ambiguous change in price depending
upon which effect dominates
Market
Pric e
Lock-in
Effect
S
Capitalization
Effect
D
Volume of Traded Stock
Evidence of “Lock-in”
• Blouin, Raedy, and Shackelford (2002)
• One-day reduction in price of 1.3% amidst
heavy trading the first trading day after
congress cut the maximum long term rate
from 28% to 20% on assets held between
12 and 18 months in June of 1998.
Evidence of “Lock-in”
• Blouin, Raedy, and Shackelford (2003)
• Value the holding incentive as
( STR  LTR)( AssetAppreciation )
• Show a significant positive (negative)
relationship between the holding incentive and
price (volume)
Which Effect Dominates?
•
•
•
•
Dai, Maydew, Shackelford, and Zhang (2006)
Taxpayer Relief Act of 1997
Cut maximum long term rate from 28% to 20%
Leaked to the public a weak before it became
effective
• Perfect opportunity to test for dominance
Testing for Dominance
• Theory leads us to expect the
capitalization effect to dominate the week
after the leak and the lock-in effect to
dominate after the cut becomes effective
• Dai, Maydew, Shackelford, and Zhang
(2006) document this empirically
Fiscal Policy Implications
• The stock market is correlated to
aggregate investment
• Sub-optimal liquidity may translate into
reduced investment and reduced
economic growth (GDP)
• Do capital gains tax cuts spur economic
growth?
Measuring Fiscal Policy
• How sensitive is the stock market to the
tax rate?
• How severe is the economic ripple effect
to aggregate investment?
• What kind of feedback does the stock
market receive from aggregate
investment?
• Is this the source of the Laffer curve?
Plan
• Attempted to design a model to test the
long run sensitivity of capital gains tax
realizations to changes in the tax rate itself
• Control for the economic environment
using GDP and for the level of unrealized
gains using the S&P 500 year-end valueweighted index
• Differentiate between short run and long
run effects of changes in the tax
Analysis
• Found the expected negative relationship
between capital gains realizations and
both tax variables, but the correlations
were not significant.
Conclusion
• The short term effect of changes in the
capital gains tax on the stock market is
well documented.
• The long term effect warrants further
research to quantify its influence on
aggregate investment and GDP.