Capital Gains Taxation and the Cost of Capital: Evidence from Unanticipated Cross-Border Transfers of Tax Bases
Harry Huizinga (Tilburg University and CEPR)
Johannes Voget (University of Mannheim, Oxford University Centre for Business Taxation, Tilburg University CentER)
and
Wolf Wagner (Tilburg University)
June 2011
Abstract: In a cross border takeover, the tax base associated with future capital gains is transferred from target shareholders to acquirer shareholders. Cross country differences in capital gains tax rates enable us to estimate the discount in the takeover price on account of future capital gains. The estimation suggests that a one percentage point increase in the capital gains tax rate reduces the valuation of new equity by 0.136%. The implied average effective tax rate on capital gains is 4.57%, indicating that capital gains taxation is a significant cost to firms when raising new equity capital. Apart from the taxation of future capital gains, we also find that takeover prices are affected by capital gains taxation resulting from the accelerated realization of past capital gains by target shareholders.
Key words : Capital gains taxation, Cost of capital, International takeovers, Takeover premium JEL classification : G32, G34, H25
1 1. Introduction Shareholder level capital gains taxation reduces the attractiveness of assets such as shares for which a large part of total investor returns comes in the form of capital gains. Thus, capital gains taxation potentially depresses share prices, and raises the cost of equity finance to firms. The measurement of the impact of capital gains taxation on the cost of capital, however, has proven difficult. This reflects that the capital gains tax is a rather complex tax. Capital gains taxes are only assessed on realized gains, and even then the capital gains tax base can be reduced by taking exemptions and deductions for realized losses. Individuals thus can reduce their capital gains tax liability by holding on to their appreciated assets, or by realizing gains that are wholly or in part offset by losses, reducing the effect of capital gains taxation on the cost of capital. Ivković, Poterba, and Weisbenner (2005) provide evidence of trading by individual investors aiming to reduce the effective capital gains tax burden. In this paper, we exploit cross border M&A data to estimate the impact of capital gains taxation on asset pricing and the cost of capital. In a cash