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Department of Accounting's Lecture


Topic:Capital Gains Taxes and the Market Response to Earnings Announcements
Speaker:William J. Moser
Time: 10:00, June 13, 2017
Place: Room 1007, Mingde Business Building

We investigate the effect of capital gains taxes (CGTs) on the market response to earnings announcements under alternative tax regimes. We explore how the differences between short-term capital gains tax rates and long-term capital gains tax rates affects price and volume reactions at firm earnings release dates as well as the earnings response coefficient (ERC). We first extend an extant theoretical model (Shackelford and Verrecchia (2002), hereafter SV) to identify the economic forces that influence equity prices and trading volume in the presence of CGTs when public information is disclosed. We then employ stock price and trading data to investigate and test empirical predictions derived from our model.  Our results indicate that price changes are magnified and volume inhibited during tax regimes in which the difference between short-term capital gains tax rates and long-term capital gains tax rates are larger.  However, the degree of magnification/inhibition for price reaction and trading volume differs across multiple well-defined regions of public signal and supply change realizations. Only in regions where rational taxable and information-motivated investors choose to sell shares at a gain are price changes magnified and trading volume suppressed, based on the difference between short-term and long-term capital gains tax rates.  We also find that it is possible for subsets of investors to choose not to trade due to the presence of a tax rate differential. The resultant loss of market liquidity causes an increase in the noise in the price change due to the presence of exogenous trade.  Finally, our model predicts and we find empirical evidence suggesting that the firm’s earnings response coefficient (ERC) increases in the presence of greater positive earnings surprises during tax regimes with higher tax rate differential for firms with appreciated stock price.  Overall, our theoretical model predicts and our results show that the tax rate differential between short-term and long-term capital gains tax rates affect firm prices, trading volume and earnings response coefficients after the release of actual quarterly earnings announcements