Earnings, however, need not eventually be paid out in dividends. In fact, the mean dividend payout for U.S. companies is less than 20 percent of current earnings with the median company paying no dividends. Instead, firms can distribute corporate profits and reduce E&P without shareholders facing dividend taxes. For example, companies can buy their own stock.
If the purchase is not pro-rata, the redemption reduces E&P, and shareholders are taxed on the difference between the proceeds and their tax basis (cost) in the stock at the capital gains tax rate. Liquidations following taxable asset acquisitions or special elections following stock acquisitions also eliminate E&P.
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The extent to which these opportunities for converting distributions from dividend taxes to capital gains taxes affect firm values is an empirical question. However, if the market expects earnings ultimately to receive capital gains treatment, valuation should be decreasing in capital gains tax rates. The appendix reviews the extant empirical literature to assess the frequency that firms utilize share repurchases, liquidations following taxable asset acquisitions, and special elections following stock acquisitions.
An Alternative Perspective
Contrary to the preceding predictions, numerous articles in the business press around the budget accord asserted that the capital gains tax reduction would lower stock prices in the short run because shareholders would respond to the rate reduction by selling appreciated properties. For example, the Wall Street Journal (May 5, 1997, page C1) reported “. . ., a burst of selling may hit the markets, strategies say.
That could be the reaction, at least temporarily, as investors with big long-term profits rush to lock in their gains.” Earlier in the year, the Wall Street Journal (February 19, 1997, page A1) reported that policymakers were advocating a January 1 effective date for any capital gains tax rate reductions “to avoid possible market disruptions that might come from investors delaying transactions in anticipation of a future effective date.”
Under certain circumstances, stock prices can be shown to be increasing in capital gains tax rates if capital gains taxes are viewed as transaction costs for which sellers demand compensation from buyers. A cut in the capital gains tax rate reduces the required compensation, lowering the costs of acquiring shares and thus lowers stock prices.
For example, suppose a shareholder has a reservation price R, at which he is indifferent between holding and selling the stock and which is unaffected by the change in capital gains rates.9 Assume the shareholder is subject to a capital gains tax rate of g and has a tax basis in the property of C. To sell, the shareholder will demand a price no less than P, where: