Capital Gains Tax Wedge as a Tobin's Tax and the Inhibition of Informed Trading
Student thesis: Doctoral Thesis
Related Research Unit(s)
A widening of the wedge between short-term and long-term capital gains tax rates is equivalent to imposing a Tobin’s tax on investors’ short-term trading, discouraging short-term arbitrage particularly by informed institutions, and impeding the incorporation of firm-specific information into stock prices. Exploiting the Taxpayers’ Relief Act of 1997 which widened the capital gains tax wedge, I find significant reductions in institutional net selling activities relative to individual net selling activities, consistent with a suppression effect of capital gains tax wedge on informed arbitrage by institutional investors. Exploiting capital gains tax regime changes over time, I find that stock price synchronicity increases in the tax wedge. This effect enhances in tax-sensitive institutional ownership in the presence of short-term gains. Firms with greater transient (dedicated) institutional ownership are more immune (vulnerable) to the tax wedge effect on synchronicity. Financial analysts as information intermediaries can mitigate the tax wedge effect on stock price synchronicity. Further, block holders in the firms’ ownership structure can enhance the interactive relation of wedge with institutional ownership (analyst following). I conclude that the tax wedge is an impediment to informed arbitrage and hurts information efficiency of the stock market.
- capital gains tax, Tobin’s tax, informed arbitrage, institutional investors, TRA1997, synchronicity