If the reservation price exceeds the share’s tax basis, the derivative is positive, indicating that a decrease in the capital gains tax rate will reduce the price that the shareholder will demand to sell his stock, potentially resulting in a price decline.

We are unaware of any study that provides evidence directly supporting this characterization of stock prices and capital gains tax rates. However, Landsman and Shackelford (1995) provide similar evidence in their examination of RJR Nabisco’s stock price during its 1989 leveraged buyout. They find a negative correlation between the price of RJR Nabisco’s stock and the average tax basis of the shares sold during the 76 trading days from initiation to completion of its buyout. In other words, shareholders facing larger capital gains taxes demanded higher prices during the buyout than shareholders facing smaller capital gains taxes. Here

A logical conclusion from their study is the compensation to cover the capital gains taxes would have been less if the capital gains tax rate had been reduced. Whether their findings in a tender offer generalize to other settings is unclear. The evidence, presented later in this paper, is inconsistent with this view in that non-dividend stocks (which are likely to produce higher capital gains on sale) react positively to the capital gains rate drop.

Development of the Budget Agreement’s Capital Gains Tax Rate Reduction

President Clinton was reelected in 1996 without endorsing a capital gains tax rate cut, and his 1998 budget, introduced in March 1997, did not propose to reduce the capital gains tax rate. However, commentators speculated that the President might accept a capital gains tax rate reduction in 1997 in exchange for Republican concessions on other issues. In March 1997, Speaker Newt Gingrich and Senate Majority Leader Trent Lott dampened expectations of a capital gains tax rate cut, stating that a balanced budget must take precedent over any tax cuts.

Although Gingrich softened his statements following an outcry by conservative Republicans, it remained uncertain whether a balanced budget was feasible, not to mention a capital gains tax rate reduction. On March 19, House Ways and Means Committee Chair William Archer said that if a tax bill were enacted in 1997, “there is no greater than a 50-50 chance” it would include reductions in the capital gains tax rate (Tax Notes, March 24, 1997).

In April 1997, the Administration and the Republican leadership released little public information about the ongoing, private budget negotiations. On April 30 the Congressional Budget Office reduced its estimate of the 1997 deficit by $45 billion and stated that annual revisions of “similar amounts” were appropriate for years 1998-2002. The CBO’s announcement was a major surprise because no revision was scheduled until August.

The next day the Wall Street Journal and New York Times announced that a budget agreement was imminent. Both newspapers speculated that the CBO’s new projections had enabled the President and Congress to balance the budget without forgoing desired expenditure programs and tax cuts.