Collins and Kemsley (1998) extend the Harris-Kemsley model to incorporate the capital gains taxes arising from secondary trading. Examining 46,584 observations from 1975-1994, they regress stock prices on book value, earnings, dividends, and the interactions of the maximum statutory capital gains tax rate with earnings and dividends. Consistent with their predictions, they report that the coefficient on the earnings (dividend) interaction is negative (positive). They interpret the coefficients on the interaction terms as evidence that capital gains taxes reduce firm value through their effect on the valuation of earnings, but that firms can offset this negative valuation effect by paying dividends.
However, Collins and Kemsley (1998) potentially suffer from a lack of variation in the maximum statutory capital gains tax rates. The capital gains tax rates were 28 percent in all years, except 1975-1978, when they were 35 percent, and 1982-1986, when they were 20 percent. Thus, the results are driven solely by differences between the study’s first four years and the five years following the 1981 rate reduction and rely critically on controls for other sources of variation between these two periods. Want an easy pay day loan that you will not be regretting after a month? Then you are in luck, because we are the lender that can make it happen for you! With our payday loans, you are no longer doomed to dealing with your financial troubles on your own. Sign up at website today and see for yourself.
Furthermore, in years of legislative change in the rates (i.e., 1978, 1981, and 1986), investors likely began to impound the capital gains tax rate before it became effective in the following year. Moreover, to the extent prices are set by the expected capital gains tax rate, rather than the current statutory rate, it becomes difficult to identify the relevant rate in several non-change years that were filled with speculation about possible changes in the capital gains tax rate.
This paper avoids these research design problems by adopting a capital markets event study methodology to test whether share prices reflect anticipated capital gain taxes. On May 2, 1997, the Clinton Administration and the Republican Congressional leaders announced agreement concerning the general features of the fiscal 1998 federal budget. Among other changes, the accord included an unspecified reduction in the maximum statutory capital gains tax rate for individuals. No adjustment in the ordinary tax rate on dividend income was proposed. This event potentially offers a more powerful test of capital gains tax capitalization than the exemptions examined by Amoako-Adu, et al. (1992) because the capital gains tax rate affects all individual investors, no matter their amount of capital gains.
If expected capital gains taxes are capitalized in equity prices and news of the agreement had not leaked to the market, then stock prices should have responded differentially to the announcement depending on the market’s assessment of the likelihood that the lower rate would affect shareholder taxes. Consistent with Amoako-Adu, et. al (1992), Harris and Kemsley (1999), and Collins and Kemsley (1998), this study uses dividend yields to proxy for the value-relevance of the expected capital gains tax.
Investors are assumed to place less (more) value-relevance on the expected capital gains tax rate when assessing firms with higher (lower) dividend yields. If equity prices reflect expected capital gains taxes, stock returns around the announcement should be negatively correlated with dividend yields.