Capital Gains, Dividends, and Taxes: Market Reactions to Tax Changes

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ABSTRACT

The purpose of this study is to examine the effect of a capital gains tax reduction on the stock price of firms that have not historically paid a dividend. If markets are semi-strong-form efficient, one would expect that the market price would have already adjusted prior to the day the announcement was made, assuming no new information was included in the announcement. If markets have not already incorporated the information, there would be a possibility for abnormal returns from investing in the stocks on the date of the announcement. This paper studies the returns from companies prior to, and subsequent to, the capital gains tax reduction announcement date and compares the price changes of non-dividend paying companies to those of similar firms that have historically paid dividends. The a priori expectation of the study is that the majority of a change in prices will take place prior to the announcement date as investors anticipate the likelihood of passage by the Congress and the President.

INTRODUCTION

From the time firms first began paying their stockholders dividends, an argument has raged between those who believe dividends add to stock value and those who believe dividends detract from stock value. Miller & Modigliani (1961) only add another school of thought by proposing that dividends are irrelevant in a world without taxes. The United States, however, is not a world without taxes and previous research finds a significant positive impact on the price of tax-favored assets from an increase in beneficial tax treatments (Scholes & Wolfson, 1992). The focus of this paper is on the effects of the 1997 reduction of the capital gains tax on the price of stocks that have not historically paid dividends to their shareholders. The study incorporates the use of parametric tests to determine the relative impact of the tax reduction on stocks that do not pay dividends compared to those that do pay dividends. This capital gains tax change was unique in that it: 1) occurred during a period of a relatively bullish market, 2) was not coupled with a change in the ordinary tax rate, and 3) occurred during an otherwise uneventful week in the stock market. These factors aid in distinguishing the unique impact of the tax change on the valuation of common stock. Other studies focus on capital gain tax reductions that are accompanied by changes in the ordinary tax rate and/or market anomalies such as the Crash of '87, which make it much more difficult to gauge the impact of the capital gains tax change.

First, it may be helpful to briefly explain the capital gains tax on equity investments and its implications for the stock market. Capital gains are defined as the increase in an asset's value over its purchase price. When the asset is sold, the resulting gains are said to be realized and now subject to taxation at the capital gains tax rate. Until the asset is sold, the gains are referred to as unrealized and are not subject to taxation. Corporate stocks account for 78% of the total amount of capital gains on all assets with the next closest category being bonds.

When Congress first established the income tax system in 1913, capital gains were taxed as ordinary income. From 1913 until the beginning of the 1980's, the capital gains tax has, at times, been a favorite way of generating revenue and generating votes, as evidenced by the political timing of changes in the tax laws. Prior to 1986, capital gains and dividend payment were taxed differently with 60% of long-term capital gains exempt from taxation. Such incentives made stocks offering higher capital gains, as opposed to higher dividends, more attractive to investors. In 1986, Congress passed the 1986 Tax Reform Act which changed the way capital gains were taxed. It essentially brought the taxation of dividends and capital gains to the same level. The act made all capital gains taxable at the same rates as other income. …