Abstract This paper discusses the impact that investor reactions to changes in capital gains tax rates may have on pre-tax market returns and, therefore, accrual of future taxable capital gains. Since investors focus on after-tax returns, market forces should work to maintain relatively stable after-tax returns, taking into account differences in risk and changes in economic conditions. This study analyzes monthly pre-tax rates of return in the Dow Jones industrial average, S&P 500 Composite Index, and the NASDAQ Composite Index during periods covered by the Revenue Act of 1978, Economic Tax Recovery Tax Act of 1981 and the Tax Reform Act of 1986. The maximum capital gains tax rate in each of these periods was 28, 20 and 28 percent, respectively. Accordingly, we would expect returns to be higher during the pre-1981 and post-1986 periods, when capital gains tax rates were highest. Our results are consistent with these expectations, however, only for returns on the NASDAQ index. For the S&P 500 index, returns were higher in the pre-1981 period than in the 1981-1986 period, but differences between 1981-1986 and post-1986 returns were not statistically distinguishable at generally accepted levels of confidence. No statistically distinguishable differences were observed across any of the periods tested on the Dow Jones Index.
Ricketts et al. (1997) studied this question.