Asymmetric Information, Corporate Myopia, and Implications for Capital Gains Tax Rates

Abstract

We develop a model of corporate myopia in which the interaction between asymmetric information and short-term trading by the firm's equity holders induces firm managers to undertake short-term projects rather than long-term projects, which are intrinsically more valuable. In this setting, we analyze the impact of a reduction in the capital gains tax rate on project selection. We show that a capital gains tax cut for investors who hold equity in the firmbeyond a certain length of time can induce optimal project selection by firm managers; an across-the-board tax cut, on the other hand, has no such impact. We characterize the long-term capital gains tax rate which eliminates corporate myopia. We demonstrate that a long-term capital gains tax cut does not create a bias toward inefficient long-term projects in situations where it is the short-term project that is intrinsically more valuable. We further show that, under certain conditions, reducing the long-term capital gains tax rate to the level required to eliminate myopic investment behavior can also lead to an increase in government tax revenues.

JEL Classification: H32