Can Raising the Capital Gains Tax Rate Ever Attract Investors?
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Policy May 5, 2016

Can Rais­ing the Cap­i­tal Gains Tax Rate Ever Attract Investors?

The tra­di­tion­al view that rais­ing rates hurts firms deserves a clos­er look.

Capital gains tax rate is like several dials affecting growth.

Yevgenia Nayberg

Based on the research of

Luzi Hail

Stephanie Sikes

Clare Wang

Cap­i­tal gains tax­es are easy to hate. Investors resent the extra cut tak­en from their earn­ings on sales of stocks, bonds, and prop­er­ty, while firms dis­like the fric­tion it adds to their abil­i­ty to attract invest­ment. For obvi­ous rea­sons, both groups tend to resist any efforts by the gov­ern­ment to raise the cap­i­tal gains tax rate. And many econ­o­mists and pol­i­cy­mak­ers think that rais­ing the tax rate on cap­i­tal gains hin­ders eco­nom­ic growth.

The rela­tion between cap­i­tal gains tax­es, firms, and investors — known as tax cap­i­tal­iza­tion” — is con­sid­ered sim­ple. When cap­i­tal gains tax rates go up — from 15% to 20%, for instance — a larg­er por­tion of investors’ prof­its is divert­ed to the gov­ern­ment, which decreas­es the investors’ expect­ed cash flow. To com­pen­sate for this decrease, investors demand a high­er expect­ed rate of return from firms. How­ev­er, this places an increased bur­den on the firm to deliv­er at this high­er rate, which is why they often cry foul when cap­i­tal gains tax rates go up.

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But what if this rela­tion were not so sim­ple? What if an increase in the cap­i­tal gains tax rate could actu­al­ly ben­e­fit the inter­ests of firms? Clare Wang, an assis­tant pro­fes­sor of account­ing infor­ma­tion and man­age­ment at the Kel­logg School, along with Luzi Hail and Stephanie Sikes of the Whar­ton School of the Uni­ver­si­ty of Penn­syl­va­nia, inves­ti­gat­ed this ques­tion by ana­lyz­ing a glob­al dataset of cap­i­tal gains tax rates and expect­ed returns.

If the tax author­i­ty decides to increase the cap­i­tal gains tax rate, firms will say, This increase will hurt our abil­i­ty to raise exter­nal financ­ing, because indi­vid­ual investors will demand a high­er return from us,’” Wang explains. But we show that in spe­cif­ic sit­u­a­tions, this line of argu­ment doesn’t hold up.”

Shar­ing the Risk

The busi­ness as usu­al” of tax cap­i­tal­iza­tion — in which the cost of cap­i­tal for firms increas­es if the cap­i­tal gains tax rate increas­es — comes from the blow that tax hikes deal to investors’ cash flows. This cash-flow effect is intu­itive to under­stand,” Wang says.

The cap­i­tal gains tax rate is not just a sim­ple lever — it’s more like sev­er­al dials. It’s nuanced, and it doesn’t always impede growth.”

Less noticed is a sub­tler con­se­quence, which Wang and her coau­thors call the risk effect.” This risk effect describes how high­er cap­i­tal gains tax rates result in the gov­ern­ment absorb­ing some of the risk inher­ent with­in those very same cash flows, because investors can off­set their tax­able gains with losses.

Let’s say you own stock,” Wang explains. As an investor, you nor­mal­ly care about the stream of cash flows in terms of div­i­dends or the val­ue of the stock when you sell. But you also care about vari­abil­i­ty in that cash flow and in the val­ue of the stock as it goes up and down. That’s the risk. It’s true that high­er cap­i­tal gains tax­es will decrease your cash flow. But it also decreas­es your risk by low­er­ing the vari­abil­i­ty of the cash flows. The gov­ern­ment takes a larg­er chunk of any gains, but at the same time, they also absorb a larg­er chunk of any losses.”

In cer­tain sit­u­a­tions, the risk-absorb­ing effect of high­er cap­i­tal gains tax­es can be a gen­uine ben­e­fit, not just a cold com­fort. One such cir­cum­stance is when investors bear big­ger risks because firms are exposed to sys­tem­at­ic risks that can­not be diver­si­fied away. Con­sid­er retail cloth­ing stores, whose sales inevitably decrease dur­ing a reces­sion, for instance, as opposed to a util­i­ty com­pa­ny, whose per­for­mance is unlike­ly to vary with changes in the over­all economy.

If you hold a port­fo­lio of stocks with high sys­tem­at­ic risk that you can­not get rid off, then the risk absorp­tion that comes through cap­i­tal gains tax­es will be more valu­able to you,” Wang explains.

This was borne out in a dataset of cap­i­tal gains tax rates and expect­ed returns gath­ered from more than 25,000 firms from 26 coun­tries between 1990 and 2004.

For firms with high sys­tem­at­ic risk, or dur­ing peri­ods when mar­ket risk pre­mi­ums were high or the risk-free rate on invest­ments such as Trea­sury bonds was low, the authors find that the gen­er­al­ly pos­i­tive rela­tion between cap­i­tal gains tax­es and expect­ed returns falls apart.

In these sit­u­a­tions, increas­ing the cap­i­tal gains tax rate has a weak­er impact on how expen­sive it is for firms to raise mon­ey from investors. And it could even turn out such that a hike in the cap­i­tal gains tax rate actu­al­ly makes cer­tain firms more attrac­tive to investors. For exam­ple, when the costs of bear­ing risk are high, investors are will­ing to trade a reduc­tion in their future cash flows for less volatil­i­ty in them.

Shades of Gray

The bot­tom line, Wang says, is that the cap­i­tal gains tax rate is not the eco­nom­ic boogey­man it is often made out to be. It’s not just a sim­ple lever — it’s more like sev­er­al dials,” she says. It’s nuanced, and it doesn’t always impede growth. In some cir­cum­stances, it could actu­al­ly induce the oppo­site effects.”

And while firm own­ers and exec­u­tives have no direct con­trol over tax rates, Wang believes that refram­ing their under­stand­ing of tax cap­i­tal­iza­tion — from a black-and-white issue to one with shades of gray — has real val­ue. Due to the risk shar­ing by the gov­ern­ment, a firm with high sys­tem­at­ic risk may become more attrac­tive to investors when cap­i­tal gains tax­es increase,” she says.

For gov­ern­ments and reg­u­la­tors who actu­al­ly do direct­ly influ­ence tax rates, Wang says that a bet­ter under­stand­ing of how cap­i­tal gains tax­es affect invest­ment is essen­tial to good policymaking.

So far, the gen­er­al belief is that reduc­ing cap­i­tal gains tax­es stim­u­lates growth and invest­ment among firms,” she says. But here we devel­op a frame­work and pro­vide some evi­dence that we hope will change the con­ven­tion­al wis­dom a lit­tle bit.”

Featured Faculty

Clare Wang

Member of the Department of Accounting Information & Management faculty until 2017

About the Writer

John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.

About the Research

Hail, Luzi, Stephanie Sikes, and Clare Wang. Forthcoming. “Cross-Country Evidence on the Relation between Capital Gains Taxes, Risk, and Expected Returns.” Journal of Public Economics.

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