Capital gains taxes and the market response to earnings announcements

ABSTRACT We investigate the stock price and trading volume effects of differential capital gains taxes applied to short- and long-term capital gains when firms disclose public information. We extend the theoretical framework developed in Shackelford and Verrecchia (2002) linking differential capital gains taxes to price and volume, allowing for positive and negative news and incorporating exogenous non-taxable, uninformed traders. Our model, like Shackelford and Verrecchia (2002), indicates that price responses to public information are magnified, and volume inhibited, when short-term capital gains attract a higher tax rate than long-term capital gains. However, the effects are more nuanced than those in Shackelford and Verrecchia (2002). Specifically, the degree of magnification/inhibition for price reaction and trading volume differs across well-defined regions of public signal and supply change realizations. We use actual stock price and trading data to empirically investigate these predictions. Our results provide strong support for the price response predictions.