Another reason to care about investment taxes

Alex
Kontoghiorghes

Do
lower
taxes
lead
to
higher
stock
prices?
Do
companies
consider
tax
rates
when
deciding
on
their
dividend
pay-outs
and
whether
to
issue
new
capital?
If
you’re
thinking
‘yes’,
you
might
be
surprised
to
know
that
there
was
little
real-world
evidence
(let
alone
UK-based
evidence)
which
finds
a
strong
link
between
personal
investment
tax
rates
on
the
one
hand,
and
stock
prices
and
the
financial
decisions
of
companies
on
the
other.
In
this
post,
I
summarise
the
findings
from

a
recent
study
which
shows
that
capital
gains
and
dividend
taxes
do
indeed
have
big
effects
on
risk-adjusted
equity
returns,
as
well
as
the
dividend,
capital
structure,
and
real
investment
decisions
of
companies.

Background

What
drives
stock
returns?
This
is
one
of
the
oldest
and
most
important
questions
in
financial
economics. While
a
lot
of
attention
has
been
paid
to
the
analysis
of
predictors
such
as
company
valuation
ratios,
market
betas,
momentum
effects,
and
so
on,
in
this
blog
post
I
advocate
that
taxes
are
an
important
and
often
overlooked
predictor
of
stock
returns.

I
advocate
this
due
to
the
findings
of
a
unique
natural
experiment
in
the
UK,
which
involved
a
lesser-known
segment
of
fast-growing
UK
publicly
listed
companies,
and
which
provided
an
ideal
setting
to
study
the
effects
of
a
very
large
tax
cut.
In
summary,
once

Alternative
Investment
Market
(AIM)
companies
were
permitted
to
be
held
in
tax-efficient

Individual
Savings
Accounts
(ISAs)
for
the
first
time
in
2013,
their
prices
became
permanently
higher
than
they
would
have
been,
their
risk
adjusted
excess
stock
returns
fell
commensurately
with
the
fall
in
their
effective
tax
rates,
dividend
payments
increased
by
a
quarter,
companies
issued
more
equity
and
debt
in
response
to
their
new
lower
cost
of
capital,
and
finally,
companies
used
their
newly
issued
capital
to
invest
in
their
tangible
assets
and
increase
pay
to
their
employees.
Want
to
find
out
more?
Keep
reading.

Background
and
methodology

Around
10
years
ago
(July
2013
to
be
exact)
the
then
Chancellor
of
the
Exchequer
George
Osborne
announced
that
stocks
listed
on
the
Alternative
Investment
Market
(AIM),
a
sub-market
of
the
London
Stock
Exchange,
could
from
August
2013
onwards
be
held
in
a
capital
gains
and
dividend
tax-exempt
individual
savings
account
(ISA)
for
the
first
time.
This
was
a
very
important
change
for
AIM-listed
companies,
and
they
had
been
calling
for
this
equalisation
of
tax
treatment
for
many
years
as
stocks
and
shares
ISAs
hold
billions
of
pounds
of
retail
investors’
savings.

Since
main
market
London
Stock
Exchange
Stocks
(such
as
the

FTSE
All-Share
companies)
were
always
eligible
to
be
held
in
ISAs,
this
provided
a
unique
natural
experiment
to
study
what
happens
to
various
company
outcomes
when
their
owners’
effective
personal
tax
rate
suddenly
becomes
zero.
To
see
how
big
this
tax
cut
was,
Figure
1
shows
that
pretty
much
overnight,
the
effective
AIM
tax
rate
for
retail
investors
(the
amount
of
return
percentage
points
paid
out
in
tax,
calculated
as
the
sum
of
the
stock’s
capital
gain
and
dividend
yield
components)
went
from
around
10%
per
year
to
0%
after
AIM
stocks
could
be
held
in
ISAs,
a
huge
decrease
in
the
world
of
personal
taxation.

Figure
1:
Average
effective
tax
rate
of
AIM
stocks
before
and
after
legislation
change

The
equivalent
effective
tax
rate
for
main
market
stocks
when
held
in
ISAs
during
this
period
was
always
0%,
which
is
why
they
are
used
as
the
control
group
in
this
study.

Using
a
difference-in-differences
approach
with
a
matched
London
Stock
Exchange
control
group,
I
investigate
the
effect
of
the
tax
cut
on
the
equity
cost
of
capital
and
company
financial
decisions.
The
matched
control
group
is
created
using
the
following
important
characteristics:
firm
size,
age,
sector,
book-to-market
ratio,
and
market
beta,
to
ensure
that
the
results
are
less
likely
to
be
driven
by
unobservable
AIM
company-specific
factors.

What
I
find

Relative
to
the
control
group,
I
find
that
AIM
stock
prices
initially
jumped
as
retail
investors
and
retail-focused
institutions
increased
their
relative
ownership
after
the
legislation
change.
I
also
find
that
long-run
pre-tax
stock
returns
decreased
by
0.9
percentage
points
per
month
to
reflect
their
lower
required
rate
of
return
(investors
no
longer
required
compensation
for
their
tax
liability).
This
amount
is
statistically
equivalent
to
the
monthly
effective
tax
rate
AIM
companies
faced
before
the
change
in
legislation
(0.9%
x
12
≈
10%).

On
the
company
side,
I
find
that
dividend
payments
increased
by
around
a
quarter
to
reflect
the
lower
tax
liability
faced
by
their
investors.
Furthermore,
in
response
to
their
lower
cost
of
capital,
AIM
companies
issued
both
more
equity
and
debt.
Finally,
in-line
with
the
‘traditional
view’
of
corporate
investment
theory,
AIM
companies
substantially
increased
their
tangible
assets
(for
example
factories,
warehouses,
and
machinery),
and
increased
total
pay
to
their
employees.
Regarding
the
external
validity
of
these
results,
it
is
important
to
mention
that
AIM
companies
are
generally
smaller
and
faster
growing
than
the
average
UK
publicly
listed
company,
and
their
relatively
more
concentrated
ownership
structure
will
also
be
a
factor
in
their
pay-out
and
investment
decisions.

Implications
for
policymakers

These
findings
have
important
policy
implications
on
a
number
of
levels.
My
study
revealed
that
changing
the
level
of
investment
taxes
is
an
effective
tool
to
incentivise
capital
flows
into
certain
assets.
When
similar
assets
have
differing
rates
of
investment
taxes,
this
can
cause
substantial
distortions
to
company
valuations,
as
reflected
by
the
large
change
in
the
annual
returns
of
AIM
listed
companies.
A
lower
cost
of
capital
means
companies
have
higher
stock
prices
and
can
raise
capital
on
more
favourable
terms.

My
findings
showed
that
equalising
investment
taxes
between
AIM
and
main
market
London
Stock
Exchange
companies
enabled
a
more
efficient
flow
of
capital
to
small,
growing,
and
often
financially
constrained
UK
companies,
and
potentially
allowed
a
more
efficient
flow
of
dividend
capital
to
shareholders
which
was
previously
impeded
due
to
higher
rates
of
taxation.

Finally,
my
findings
show
that
a
permanently
lower
cost
of
capital
incentivised
AIM
companies
to
issue
more
equity
and
debt
post
tax-cut,
and
companies
used
this
new
capital
to
invest
in
their
tangible
capital
stock,
and
increase
the
total
pay
to
their
employees,
which
was
a
stated
intended
consequence
of
the
legislation
change.

Alex
Kontoghiorghes works
in
the
Bank’s
Monetary
and
Financial
Conditions
Division.

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