CAPITAL GAINS TAXES: Empirical Analysis 3


To control for the normal covariability between dividend and non-dividend stocks, we estimate a regression of each firm’s weekly return for the 129 weeks from January 1995 through the event week (239,296 observations) on two variables: (a) the average return for dividend-paying stocks during the week and (b) a categorical variable for non-dividend-paying stocks in the event week. Inclusion of the average return for dividend-paying stocks should control for normal covariability. The categorical variable should capture any “abnormal” returns to nondividend stocks relative to dividend stocks during the event week.

The coefficient on the categorical variable is 5.79, indicating that non-dividend stocks outperformed dividend stocks after controlling for the normal covariability between dividend and non-dividend stocks. The coefficient estimate is only slightly less than the 6.24 coefficient in Table 2, Panel A, and remains statistically significant. Results are qualitatively insensitive to alternative specifications of the abnormal returns model.

The positive market return for both dividend-paying firms and non-dividend-paying firms during the week is consistent with the budget agreement being good news for the market as a whole. During the week, the Dow Jones Industrial Average rose 6 percent and the Nasdaq

Composite rose 10 percent.16 However, readers should be cautious to infer that the tax cut increased stock prices because the budget accord occurred in the early stages of a surge in stock prices. Specifically, the Dow Jones Industrial Average climbed from under 6400 in mid-April to over 8200 in early August. Nevertheless, the week in question did account for 58 percent of the Dow’s increase and 67 percent of the rise in the Nasdaq Composite in April and May.
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In addition, the Dow Jones Industrial Average and the Nasdaq Composite were largely unchanged in the week preceding and the week following the agreement. The DJIA rose 2 (1) percent in the week preceding (following) the accord week. The Nasdaq rose 1 (0) percent in the week preceding (following) the accord week. Moreover, a casual review of the business press during that week reveals no particularly newsworthy events, other than the accord. Thus, the evidence suggests that investors viewed the budget agreement as favorable regardless of dividend status.

At a minimum, the sharp rise in share prices following the accord overwhelmed any possible sell-off of appreciated securities. Recall that the business press widely reported that the capital gains tax rate cut would unleash selling pressure that would drive down the prices of stocks that had already appreciated. In addition, this paper provides no evidence supporting a reduction in transaction costs, arising from sellers demanding less compensation for capital gains taxes following the rate reduction.

The results imply that any downward price movement caused by sell-offs or by reduced transaction costs was more than offset by upward price pressures. Specifically, the DJIA increased on May 7, the effective date for the lower rates, and during the week beginning with May 7. By the end of the month, the DJIA (Nasdaq) had risen 1.6 (4.8) percent since May 6.