Capital Gains Taxation and Stock Market Investments: Empirical Evidence

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ABSTRACT

The objective of this study is to examine stock market investments responses to changes in capital gains tax rate. A priori, rational taxpayers are expected to respond to changes in this tax rate. For example, a reduction (increase) in capital gains tax rates may make taxpayers to unlock (lock-in) substantial amounts of accrued (realizable) appreciated gains. The findings of this study however reveal that capital gains realization and not capital gains tax rates impacts stock market investments in the U.S.

JEL: M40, M41

KEYWORDS: Stock Market Investment, Capital Gains Tax Rates, Realized Capital Gains

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INTRODUCTION

In many countries, including the U.S., the concept of deferral is central to capital gains taxation. That is, capital gains are taxed when 'realized' after sale or exchange of the eligible capital assets. On one hand, Haig-Simons 'pure net accretion' regime demands that capital gains (losses) should be subject to tax (deduction) in the year they accrue thereby requiring taxpayers to estimate realizable value of appreciated taxable assets. This may force taxpayers into untimely and inefficient liquidation of some assets in order to meet ensuing capital gains tax liability and obligations. Undoubtedly, this violates the fairness principles inherent in the U.S. taxation system. On the other hand, the double taxation argument ideally suggests a zero capital gains tax on capital accumulation. In corollary, incomes from capital gains enjoy preferential tax treatments.

Arguably, the preferential treatment of capital gains income (especially of long term character) contradicts tax equity doctrine, which suggests that all income (capital gains or ordinary income) should be taxed at same rates. It becomes pronounced if one considers the tax treatment of the 'carried interest' component of the compensation package of hedge fund managers. In fact, the Congressional Budget Office estimates that the treasury will bring in over $20 billion dollars additional tax revenue between 2012 and 2021 if'carried interest' is treated as ordinary income and taxed at ordinary income rates (CBO, 2011). No wonder then that the literature on desirability of capital gains tax is at best inconclusive in terms of its desirability and optimum capital gains tax rate level that maximizes economic efficiency.

It is widely believed that high-end taxpayers with long-end holding period and substantially appreciated capital assets have the tax and financial incentive to postpone otherwise efficient realization of capital gains in order to defer capital gains tax liability, and that in some cases avoid it by waiting until death in order to enjoy the step-up basis associated with estate taxation. This is a classical manifestation of the lock-in effect rule (Ivkovich et al., 2004. See also Elton et al., 2010) as this allows for resetting the capital assets' tax bases (including the unrealized capital gains) at death. In addition to potential loss in tax revenue, this rule certainly distorts optimal investments portfolio and diversification strategy as capital could be trapped in inefficient investment outcomes. However, the extent at which investors believe in the ability of current tax rates to predict future tax liability remains an empirical question.

Focusing mainly on capital gains generated through stock market transactions, this study attempts to empirically examine whether, on aggregate, investors/taxpayers fully and truly respond to the interaction between changes in capital gains tax rate and capital assets liquidation in a 'rational' way. A priori, rational taxpayers are expected to respond to changes in this tax rate. For example, a reduction (increase) in capital gains tax rates may make taxpayers to unlock (lock-in) substantial amounts of accrued (realizable) appreciated gains. This study specifically finds that on aggregate, total capital gains realized and not necessarily capital gains rate affect stock market investments in the U. …