Cross-Country Evidence on the Relation between Capital Gains Taxes, Risk, and Expected Rates of Return

• In Event: Ongoing Research Session I

Abstract

This study empirically tests the prediction in Sikes and Verrecchia (2012) that the relation between capital gains tax rates and expected rates of return varies in the cross-section and over time with firm risk and market risk. Specifically, the general positive relation between expected rates of return and the capital gains tax rate should become weaker or even reverse when (i) a firm’s systematic risk is high, (ii) the aggregate market risk premium is high, or (iii) the risk-free rate is low. Using a global panel from 44 countries over the 1990 to 2004 period, we find that on average and over all sample years the relation between capital gains tax rates and firms’ realized buy-and-hold returns or implied costs of capital is positive. However, once we separate between firms with high/low systematic risk and time periods with high/low country-level market beta or risk-free interest rates, the positive relation becomes weaker and in certain instances even negative, as predicted by theory. The results are particularly pronounced in countries with low tax evasion and around changes in the risk proxies. We further corroborate our findings in a single country setting, using the 1978, 1997, and 2003 changes in capital gains tax rates in the U.S. as events. Our results underscore the importance of macroeconomic and firm-specific factors for the anticipated effects of tax rate changes and their impact on firm-level investment.

Authors

• Luzi Hail, University of Pennsylvania

• Stephanie A Sikes, University of Pennsylvania

• Clare Wang, Northwestern University