The following day, May 2, the President and Congressional leaders announced an agreement to balance the budget by 2002 and, among other things, reduce the capital gains tax rate. At the announcement OMB Director Raines admitted that the revision had enabled the negotiators to “make some adjustments.” He stated that the revision had provided an additional tax revenue, enabling a balanced budget in 2002. On May 7, Senate Finance Chairman William Roth and House Ways and Mean Chairman William Archer jointly announced that the effective date for any capital gains tax cut would be May 7.
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The capital gains tax rate was not specified in the agreement, but the business press immediately began to speculate that maximum rates between 15 percent and 20 percent were likely, down from the current rate of 28 percent. After three months of haggling over details, the general features of the May budget agreement were codified in the Taxpayer Relief Act of 1997 (TRA 97).11 Among other changes, it lowered the individual maximum long-term capital gains tax rate to 20 percent.
The sudden budget agreement following the CBO’s unexpected revisions potentially provides an unusually powerful setting for assessing the value relevance of U.S. taxes. Typically U.S. tax legislation is constructed over long periods–many months or even years. Information leaks during policy deliberations impede identification of an event period and thwart successful use of conventional event study methodology. This study’s research design assumes that the information about future capital gains tax rates was dispersed to market participants in a sufficiently brief period that conventional capital market methodologies can detect the effect of capital gains taxes on firm values.
Generally, such methodologies have been relegated to tax changes in parliamentary governments (e.g., Amoako-Adu, et al. (1992)) where tax and budget information is strictly confidential and information links can result in removal of top government officials. One exception is Cutler (1988), who tests for a market response to each house’s passage of the Tax Reform Act of 1986. Failing to detect a large market response, he concludes, “These results leave unanswered questions about what the tax news meant to the market, and whether the news was efficiently incorporated in stock prices (p. 1108).”
One possible explanation for Culter (1988)’s weak results is that it may have taken time for investors to price the complex revisions in 1986 tax reform.13 If so, our study may find a stronger price response to taxes because the valuation implications of the relatively simple 1997 capital gains tax rate cut should have been more quickly impounded into price.14
The empirical analysis is based on the observation that, if expected capital gains tax rates affect valuation, then stock prices should increase for firms on the announcement of the budget agreement, and particularly so for firms that pay less in dividends. The basic regression is:
Return = a + Pi Dividend Variable + p2 Control Variables + e (12)