Tax Induced Trading Around the Taxpayer Relief Act of 1997

Abstract

We examine investor trading around the passage of the Taxpayer Relief Act of 1997 (TRA97) that reduced the capital gains tax rate from 28% to 20%. We provide evidence that individual investors increase their demand for equity shares on the announcement day of TRA97, consistent with the capitalization of capital gains taxes. On the effective day of TRA97, we find that individual investors increase the supply of equity shares with accrued gains, consistent with the lock-in effect of capital gains taxes. Regression results suggest that tax capitalization is associated with a more powerful effect on abnormal trading than the lock-in effect for the median stock trading around TRA97. Overall, our results suggest that capital gains taxes influence both the demand and supply for equity by tax sensitive investors and that the effect on demand is more pronounced than the effect on supply.

Keywords: Taxation, Dividend tax capitalization, Lock-in effect, Trading volume

JEL Classification: G10, H24