American Economic Association
Tax Reform and the Stock Market: An Asset Price Approach
Author(s): David M. Cutler
Source: The American Economic Review, Vol. 78, No. 5 (Dec., 1988), pp. 1107-1117
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1807170
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Tax Reform and the Stock Market:
An Asset Price Approach
By DAVID M. CUTLER*
The incidence of the corporate income tax
has been a subject of much dispute. Traditionally, the debate has focused on the importance of general equilibrium effects in
evaluating tax burdens. In applied work, incidence analysis has often consisted of estimating the changes in future tax payments
from tax reforms. These "cash flow" models
of incidence implicitly assume that the relative price effects of tax reforms are unimportant. In general equilibrium analyses, however, these relative price effects, particularly
changes in the price of existing capital, are
important determinants of the tax burden.
"Asset price" models of incidence can consequently yield predictions quite different from
those of cash flow models. In theory, the
general equilibrium effects associated with
the asset price approach are well understood,
but little is known about their empirical
magnitude.'
*Department of Economics, Massachusetts Institute
of Technology, Cambridge, MA 02139. I am grateful
to Alan Auerbach, Larry Katz, Greg Mankiw, Peter
Reiss, two anonymous referees, and especially Martin
Feldstein, Jim Poterba, and Lawrence Summers for
useful discussions and comments on an earlier draft.
Financial support from a National Science Foundation
graduate fellowship is gratefully acknowledged.
'Formal discussions of the asset price model and its
relation to other incidence methods are in Andrew
Abel, 1982; Alan Auerbach, 1986; and Lawrence Summers, 1981, 1985; though the distinction between taxes
on new and old assets was noted at least by Richard
Musgrave: "In the long run, this [tax on new investment] may lead to a decline or increase in the supply of
capital, with resulting changes in yield of new assets.
These, in turn, give rise to a revaluation of existing
assets, and may involve changes in the relative yields
and capital values of various assets." [1959, p. 384]. One
cash flow model which does allow for many of the
general equilibrium effects is Thomas Downs and Patric
Hendershott, 1987. Empirical studies of the asset price
approach include Andrew Lyons, 1986; and Downs and
Hassan Tehranian, 1988.
This paper assesses these asset price effects by examining the stock market's reaction to the Tax Reform Act of 1986. The
1986 Tax Act presents a unique natural experiment for studying asset pricing theories.
The Act changed the overall corporate tax
burden (a $120 billion increase over five
years), the tax rate on corporate income (a
decrease from 46 percent to 34 percent), and
the relative treatment of old and new capital
(the repeal of the investment tax credit and
lengthening of depreciation lifetimes). These
changes could produce substantial cross-firm
heterogeneity in the reaction to tax news.
The paper uses a "differential effects"
event study to evaluate the market response.2
The analysis focuses on two key events in
the tax bill's progress: the vote by the House
of Representatives for the bill in December
1985, and the vote for a similar bill by the
Senate Finance Committee in May 1986.
Both events came as surprises to the financial community and are therefore well suited
to an event study.
The analysis leads to two conclusions.
First, there is some evidence confirming the
predictions of the asset price model. After
accounting for changes in future cash flows,
firms with greater shares of equipment in
their capital stocks benefit from the tax
change, while firms with greater pre-reform
investment rates suffer share declines. These
results suggest that the differential taxation
of new and old capital could have substantial effects on market values. Second, however, the paper finds little evidence of a large
market response to tax news. Excess returns
on days containing similar tax news are essentially uncorrelated, and overall market
2See Nancy Rose, 1985, for a comparison of this
approach with alternative methods of estimating the
effects of changes in policy on corporate returns.
1107
1108
THE AMERICAN ECONOMIC RE VIEW
reactions to the tax news are small. These
results leave unanswered questions about
what the tax news meant to the market, and
whether the news was efficiently incorporated in stock prices.
The structure of the paper is as follows.
Section I discusses the asset price approach
to incidence, as well as a competing cash
flow approach. Sections II and III detail the
methodology employed and identify dates of
changing tax expectations. Section IV examines cross-sectional incidence tests. Section
V considers more general tests of market
movements. Section VI concludes.
I. Tax ReformandMarketValue
Two approaches have traditionally been
advanced for studying the effects of tax reform on market value. The first is a cash
flow approach. Cash flow analyses evaluate
tax incidence by estimating changes in aftertax income. While reform-induced demand
shifts are sometimes incorporated in these
analyses, other general equilibrium effects
typically are not. More commonly, the focus
is on computing changes in corporate tax
payments.
The cash flow approach predicts a substantial market fall in response to the 1986
Act. The House of Representatives' (1986)
forecast of corporate tax payments indicates
that the Act should raise $84 billion in real
terms over its first five years.3 The effect of
this increase on share values should be
tempered by the reduced taxation of corporate dividend payments. Estimates by Jerry
Hausman and James Poterba (1987) suggest
that the marginal tax rate on dividends will
fall by 8.1 percent under the new law, which,
assuming historical average real dividend
growth of 3.4 percent per year, yields a
five-year tax savings of $35 billion. The net
effect of the reform is thus an increase of $49
billion in the shareholder tax burden, or
about 2.5 percent of the end of 1985 value of
the stock market.
3See Alan Auerbach and James Poterba, 1987, for
details of the calculation.
DECEMBER 1988
While the cash flow approach correctly
focuses on after-tax returns, it ignores many
general equilibrium effects. These are highlighted in the asset price model of incidence.
The asset price approach stresses changes in
the value of existing assets from tax reform,
in addition to the change in future tax payments. Policies that alter future marginal
products also affect the value of existing
assets through their impact on the supply of
capital-intensive goods and thus on product
market prices. If these general equilibrium
effects are large, they can reverse the partial
equilibrium analysis. Consider, for example,
the repeal of the investment tax credit. This
change reduces the after-tax return to new
equipment,4 but increases the value of existing equipment, which now competes with
more expensive (after-tax) new equipment.
Higher returns on old capital therefore partly
offset the higher taxes that firms must pay
on new capital. The net effect on share values is ambiguous, depending on specific
technological and adjustment cost assumptions. The asset price approach does, however, offer cross-sectional predictions about
the response to tax news. These are detailed
in the next section.5
II. Methodology and Data
To measure the impact of tax reform on
market value, I examine the excess returns
caused by tax news. I use the market model
4Since the investment tax credit applied only to
equipment, the tax change hurt equipment investment
more than structures investment. Auerbach, 1987,
estimates that the tax reform increased the effective tax
rate on equipment from - 3.3 percent to 38.0 percent,
and lowered the rate on structures from 45.6 percent to
37.0 percent.
sThe 1986 Act also changed the taxation of personal
income, which could affect the value of corporate distributions. I consider some of these changes in the empirical work, but concentrate on the corporate tax changes.
I also ignore the implications of the asset price model
for the transition after the tax news. Since the two
events I consider contained similar news, the change in
prices after each should be similar; the transitions after
the votes, in contrast, need not be. Further, the phasing
in of many of the tax changes and the retroactive repeal
of the investment tax credit make the determination of
the transition path difficult.
VOL. 78 NO. 5
CUTLER: TAX REFORM AND THE STOCK MARKET
to measure these returns:
(1)
Rit = ai +fiRmt
+
Eit,
where Rit and Rmt are the return to stock i
and the market (m) at time t. The coefficient
,Bi= cov(Ri, Rm)/var(Rm) is the share of the
return that cannot be fully diversified. The
excess return is then the residual, Eit.6 The
firm sample is the 1985 Fortune 500 largest
industrial corporations.7
To examine the incidence hypotheses, I
model the excess returns as a function of
firm asset and financial characteristics:
(2)
ERET, =T? + T1M&ESHARE,
? 2INVI ?T3NETKj+
'T4ATR
+ T LA
CASHFLO Wi+ (i,
where ERETi = -iH+?is, the combined excess return from the days or weeks around
the House and Senate Finance Committee
votes.8 The first three variables are measures
of the firm's assets. M&ESHARE is the
percentage of the 1985 gross book value of
the capital stock accounted for by machinery
and equipment (found in the annual report
of each company).9 INV and NETK are
the average growth rate of the net capital
61 use daily return data from January 1985 to
November 1986. The data were adjusted for dividend
payments and stock splits. The return on the Standard
& Poor's Composite Stock Index was employed as a
proxy for the market return.
7An industrial corporation is one in which over 50
percent of the sales are from mining or manufacturing.
The Fortune list was selected because annual reports are
more readily available for these firms, and because the
companies in the Fortune survey are ranked on sales,
not profits. The sample thus should not be self-selected
for profitability. In fact, a record number of firms (70)
lost money in 1985. Due to missing data, the sample
was reduced to 336 of the 500 firms.
xI report OLS estimates of equation (2), though
differential variances of the error terms in equation (1)
would result in heteroskedastic errors in equation (2).
Using weighted least squares has no significant effects
on the estimates.
9A more appropriate specification would use the percentage of equipment in the net capital stock. Firms
only report asset types by gross value, however.
1109
stock from 1982 to 1985 and the net book
value (in millions of dollars) of the capital
stock in 1985. Both variables are from
COMP US TAT.
The last two variables highlight the tax
payments of the firm. ATR is the firm's 1985
average tax rate, while ACASHFLOW is the
projected change in annual tax payments
from the tax reform. ACASHFLOW is found
by recomputing the corporation's 1985 average tax rate under 1988 tax rules and multiplying this change by the ratio of the tax
base of the firm to the value of equity.'0 The
data on average tax rates and changes in
average tax rates are from Tax Analysts
(1985, 1986).1" The other variables are from
COMP US TAT.
The two incidence hypotheses offer different predictions about the importance of
these explanatory variables. The cash flow
approach predicts that the projected change
in tax payments should be positively related
to the firm's excess stock return, but that the
other variables should not. After controlling
for future taxes, no pre-reform aspects of the
corporation should influence share prices.'2
The asset price approach similarly suggests that the change in cash flow should be
positively related to excess returns, since this
measures the direct effects of the reform on
tax liabilities. The other variables capture
the relative price effects. Holding constant
future taxes and the stock of existing capital,
an increase in the equipment share of the
capital stock increases the amount of the
'0The tax base is imputed as the sum of federal and
foreign tax payments and investment tax credits utilized, divided by the statutory tax rate in 1985 (46
percent).
"1Tax Analysts did not compute the average tax rate
or projected change in the average tax rate for a small
number of firms. For these firms, the variables utilized
were the weighted average estimates for the relevant
industry. The results do not change across samples.
12If the tax bases of firms grow at different rates, or
if the 1986 and 1987 transition rules differ greatly from
the fully implemented provisions, the recalculations of
the average tax rates may not be a complete estimate of
the total changes in cash flow. While part of these
differences may be captured by the industry dummies,
the noise in the estimates suggests that the coefficients
on the change in cash flow could be downward biased.
1110
THE AMERICAN ECONOMIC RE VIEW
firm's existing capital that is in competition
with the less subsidized new equipment, and
thus should positively affect excess returns.
Similarly, the investment rate should be
negatively related to excess returns, because
faster-growing firms have younger capital
stocks and thus generate larger depreciation
deductions. The reduced corporate rate decreases the value of these deductions, so
that, for equal final capital stocks, higher
growth firms should experience larger windfall losses. Finally, the pre-reform average
tax rate should have a negative effect on
excess returns. Low average tax rates are
associated with tax loss firms, or firms nearing tax losses. Since the tax act increases
overall corporate tax payments, the value of
existing tax losses should rise."3
III. Expectationsof Tax Changes
Two events dominated the history of the
1986 Tax Act. In December 1985, the House
of Representatives voted for major tax reform, and in May 1986, the Senate Finance
Committee voted for a substantially similar
bill. Both of these votes came as surprises to
the financial community."4
For most of 1985, the tax reform bill was
stuck in the House of Representatives. As
late as mid-December, the full House had
not yet received the bill for consideration.
On December 11, two tax bills were introduced on the House floor. The first (Republican) bill was defeated as projected, but in a
surprise move, the second (Democratic) bill
failed to pass. The headlines on December
12 proclaimed "Reagan Loses Key Tax
Vote," and the House adjourned for the
weekend "with the prospects growing dimmer that a tax bill can clear the House this
year." [New York Times, December 13,1985,
IV, 1:3]
13This effect is partly mitigated by the repeal of the
General Utilities doctrine and the strengthening of
ownership requirements to utilize acquired operating
losses, both of which make the transfer of tax losses
more difficult. It is difficult to find proxies to control for
these effects, however.
14The discussion of the tax bill here is necessarily
brief. For a narrative of the bill's history, see Jeffrey
Birnbaum and Alan Murray, 1987.
DECEMBER 1988
Lobbying over tax reform continued that
weekend and early the next week. On December 17 (Tuesday), the bill was reintroduced in the House. It was passed later that
day, although the vote was not held until
11:00 P.M. The timing of the change in expectations is unclear. It is conceivable that
investors anticipated the outcome on Tuesday, though it was not until the discussion of
Wednesday's market movement (on Thursday) that the New York Times mentioned
the bill influencing traders. "Another negative for the stock market was the House
passage Tuesday night of its version of the
tax-revision bill," it reported. [December 19,
1985, IV, 14:4] Accordingly, I use the return
on December 18 (Wednesday) as the immediate response to tax news.
After passing the House, the tax bill was
sent to the Senate Finance Committee, where
it remained for almost half a year. For most
of this period, little progress was made toward approval. As late as May 4, 1986, the
New York Times noted that the prospects
for passage looked dim. Powerful lobbyists
were strongly against the bill. After working
all day on May 6 (Tuesday), however, the
Senate Finance Committee voted on and
passed a tax bill. As with the House passage,
the vote was not taken until late at night,
this time at 12:30 A.M. on May 7. The New
York Times noted that the outcome was
uncertain until a late-night agreement was
reached leaving in oil and gas tax shelters. Thursday's paper carried the headline "Tax Revision in 1986 is Almost Assured, Lawmakers Insist," and reported that,
"Leading Senators and Representatives from
both parties said today (May 7) that the
Senate Finance Committee's unanimous approval of a tax bill meant that comprehensive tax revision legislation would almost
certainly be enacted by the end of this year."
[May 8, 1986, I, 1:6] As with the House vote,
I use the day after the vote (May 7) as the
immediate response to tax news.
IV. The Effect on Market Values
The most natural test of the reaction to
tax news is the change in aggregate share
values. The cash flow hypothesis predicts a
VOL. 78 NO. 5
CUTLER: TAX REFORM AND THE STOCK MARKET
large decline from the capitalization of the
increased taxes, while the predictions of the
asset price model are ambiguous. The actual
response to the votes was negative but small
in magnitude. On the day after the House
vote, the S&P 500 fell by 0.40 percent; after
the Senate Finance Committee vote, the index fell by 0.49 percent. These responses do
not appear to stem from mis-specified dates
of expectations changes. On the previous
days, the index fell by 0.65 and 0.21 percent.
In fact, for the 10-day period spanning the
two votes, the index fell by 0.65 percent for
the House vote, but actually rose by 1.19
percent for the Senate Finance Committee
vote.'5 The aggregate market statistics thus
seem inconsistent with large share declines,
though the overall movements do little to
estimate the relative price effects. The remainder of this section examines excess
returns using industry- and firm-specific
returns.
A. Industry-BasedTests
Most incidence analyses are conducted on
industry aggregates. This is both because
demand shifts from the tax reform would
plausibly be concentrated along industry
lines,'6 and because firms in an industry may
be similar enough to merit common treatment. To test these hypotheses, Table 1 presents the average excess returns for the firms
in each industry. The industries are grouped
into "winners" and "losers" based on newspaper and magazine discussions of the bill's
likely effects. The first column reports the
predicted changes in one year's net income
from one of the quantitative assessments of
'5Other measures of market activity also show little
movement. Market volume on the day after both votes
(138 million and 130 million shares for the House and
Senate Finance Committee votes) was near average for
that week (154 and 125 million shares) and only average
for that month (137 and 127 million shares). The same
is true of the 10-day volume moving average, the number of new highs and lows, and the number of advances
and declines.
16
16A common prediction was that the shift in the tax
burden from households to corporations would increase
demand for consumer goods and decrease demand for
corporate equipment.
1111
the tax bill, the Shearson-Lehman Brothers
projections (Walter Dolde, 1986, and Allen
Sinai, 1986). The Shearson projections are
similar to other discussions in the financial
press.
The remaining three columns present the
industry average return for different time
periods: the day after both votes, the 10-day
(6-market day) period encompassing the
weekend before and after each vote, and the
one-month period beginning the Friday before the vote and extending after the vote.
The industry returns provide little evidence
that reactions to tax reform fell along industry lines. For most industries, one cannot
reject the hypothesis of zero excess return.
Further, the predicted and actual effects seem
only weakly correlated. The industries with
above-average predicted changes in income
do not appear to have above-average excess
returns. In fact, most of the industries in the
"losers"' category were consistent winners
in the stock market,'7 although the predicted
winners fared well on average. The results
are generally unsupportive of industry-based
measures of tax incidence.
B. Firm-Specific Tests
Since industry-level predictions are only
partly consistent with the observed reaction,
I examine returns on a firm-specific basis.
Table 2 presents the results for estimating
equation (2). I include industry dummies to
control for industry effects and estimate the
equations over different time periods to examine the timing of the market reaction.
The estimates in Table 2 lead to three
conclusions. The most significant result is
the distinction between high growth firms
and firms with large existing equipment
shares. Exclusive of the one-day return, firms
with high investment rates suffer from the
tax reform; the effects are significant and
increase in magnitude with longer time periods. In contrast, firms with large shares of
'7The oil and gas industry did well after the Senate
Finance Committee vote because of the already noted
depletion provisions included in the bill. For the other
industries, however, special provisions do not appear to
be important.
THE AMERICAN ECONOMIC RE VIEW
1112
TABLE 1-ESTIMATED
Industry
Predicted Winners
Appliances
AND ACTUAL TAX REFORM WINNERS AND LOSERSa
Predicted
Change in
Net Income
(percent)
8.40
Apparel
5.10
Wholesale and
Retail Trade
Service
4.50
Media
1.10
Predicted Losers
Electrical Machinery
1.80
- 5.65
Aerospace
- 5.82
Machinery and
Equipment
Communication
- 6.39
-15.00
Metals and
Mining
Oil and Gas
- 20.30
Heavy Industry
- 76.43
Indeterminate
Dairy Products
14.78
Stone, Clay, and
Plastics
Drugs
DECEMBER 1988
-18.50
13.12
9.60
Furniture
8.40
Measuring
Instruments
Food and Tobacco
7.83
6.00
Textiles
5.10
Beverages
3.40
Engines and
Turbines
Office Machinery
1.10
-0.02
Automobiles
-13.30
Miscellaneous
Manufacturing
Chemicals
- 15.60
Paper and Lumber
- 25.80
- 23.20
Excess Returns Over
One
Day
Ten
Days
One
Month
1.35
(1.45)
0.36
(1.02)
0.37
(1.12)
1.76
(1.77)
0.76
(0.72)
2.55
(3.02)
2.54
(2.14)
0.98
(2.34)
1.27
(3.70)
1.00
(1.51)
6.02
(5.00)
7.13
(3.54)
-0.27
(3.87)
- 3.20
(6.12)
1.70
(2.50)
- 0.03
(0.54)
0.30
(0.65)
1.46
(0.50)
- 0.38
(0.95)
0.24
(0.58)
1.33
(0.46)
- 0.53
(0.76)
- 2.20
(1.12)
- 0.30
(1.35)
3.48
(1.05)
- 0.08
(1.98)
-0.96
(1.23)
3.97
(0.26)
0.09
(1.58)
- 2.03
(1.85)
- 2.65
(2.24)
4.29
(1.77)
- 4.11
(3.27)
0.36
(2.04)
2.98
(1.61)
1.09
(2.61)
- 0.08
(1.45)
-0.32
(0.67)
- 0.86
(0.70)
- 0.49
(2.51)
- 1.32
(0.79)
- 0.18
(0.51)
0.44
(0.89)
- 0.53
(0.95)
-0.11
(1.12)
0.25
(0.65)
- 1.15
(0.63)
-0.97
(1.12)
0.02
(0.45)
-0.29
(0.58)
- 5.60
(3.02)
-0.34
(1.40)
- 1.99
(1.45)
- 0.23
(5.23)
- 3.76
(1.65)
- 0.48
(1.07)
0.74
(1.85)
- 3.54
(1.98)
2.70
(2.34)
0.27
(1.40)
- 4.39
(1.35)
- 0.97
(2.34)
0.10
(0.94)
- 0.09
(1.20)
- 6.06
(5.00)
-2.38
(2.31)
- 2.30
(2.40)
0.03
(8.66)
2.59
(2.74)
- 2.79
(1.77)
7.55
(3.06)
- 1.37
(3.54)
8.89
(3.87)
-0.31
(2.31)
- 3.14
(2.16)
6.16
(3.87)
0.10
(1.56)
1.48
(2.04)
VOL. 78 NO. 5
CUTLER: TAX REFORM AND THE STOCK MARKET
1113
TABLE 1-CONTINUED
Predicted
Industry
Rubber
Change in
Net Income
(percent)
- 34.20
N
One
Day
-0.16
(0.89)
0.09
336
Excess Returns Over
Ten
One
Days
Month
- 3.13
(1.85)
0.17
333
- 2.03
(3.06)
0.12
330
Sources: Stock return data are from Data Resources, Inc. Changes in net income are
from Dolde (1986) and Sinai (1986). Periodicals used in grouping industries were the
New York Times, Wall Street Journal, Fortune, and Business Week.
aThis table shows predicted change in net income and mean excess return for each
industry. Excess returns are the sum of the returns for the House and Senate Finance
Committee votes. Industries were grouped by newspaper and magazine discussions of
tax reform. Industries in the "Indeterminate" category either had no predictions made
about them, or were predicted as a winner by some analysts and a loser by others.
Standard errors are in parentheses.
formerly ITC-qualifying equipment increase
in value in response to tax news, though the
estimates are less significant when industry
effects are included. Both of these results
support the predictions of the asset price
model of incidence.
The equipment share and investment rate
coefficients are broadly consistent with the
predictions of the asset price theory.'8 The
coefficient on the investment rate measures
the difference in the losses on existing depreciation allowances for firms with different
rates of investment. Using aggregate data, it
is possible to provide an estimate of these
effects. For a given nominal discount rate
(8 percent), it is possible to calculate the
present value of depreciation allowances
(under the 1985 tax law) for a unit of equipment and structures of every vintage. Given
constant depreciation rates, the stock of depreciation deductions on existing assets can
then be computed for different rates of investment. Evaluated at the 1982-85 average
18It is possible that firms with large amounts of net
investment suffer because their returns to shareholders
are conveyed in the form of capital gains, which are
taxed more heavily under the new law. Including the
dividend-earnings ratio to measure these payout effects,
however, does not change the estimated coefficients.
Further, the coefficient on the dividend-earnings ratio is
small in magnitude and insignificant statistically.
net investment rates, a 1 percent increase in
investment, split between equipment and
structures in the ratio of the outstanding
stocks (70 percent equipment in the sample)
results in a 3.1 percent increase in the stock
of depreciation allowances. The rate cut,
then, reduces the value of these allowances
by 0.37 percent. Empirically, the largest estimate of this effect is about one-third this
magnitude. The predicted changes are larger
than the observed changes, though allowing
for the less favorable tax law before 1981,
slower growth in the 1970s, and an effective
tax rate change of less than 12 percent would
reduce the differences in the stocks of allowances.
The coefficient on the equipment share is
more difficult to evaluate because it depends
on how quickly the capital stock adjusts to
the tax change. A quick adjustment would
imply large windfalls from the repeal of the
investment tax credit but smaller windfalls
from the rate cut. It is possible to provide
some estimates of these magnitudes. Auerbach (1986) solves the asset price model
analytically and simulates the impact of the
1986 tax reform. He finds that the tax change
should result in equal revaluations of equipment and structures when adjustment costs
are large, but that each dollar of equipment
should increase in value by 0.07 percent more
than a dollar of structures when adjustment
THE AMERICAN ECONOMIC RE VIEW
1114
TABLE 2-TAX
Period
One Day
One Day
Ten Days
Ten Days
One Month
One Month
Machinery
and
Equipment
Share
.018
(.012)
.000
(.015)
.083
(.025)
.035
(.031)
.064
(.043)
.024
(.051)
DECEMBER 1988
CHANGES AND MARKET VALUEa
Rate of
Investment
Net
Capital
Stock
Average
Tax Rate
Predicted
Change In
Cash Flow
-.004
(.006)
-.003
(.006)
-.029
(.013)
-.028
(.013)
-.131
(.042)
-.158
(.044)
.037
(.033)
.032
(.036)
.068
(.070)
.044
(.075)
-.025
(.117)
-.027
(.124)
-.002
(.004)
-.003
(.005)
-.009
(.010)
-.011
(.010)
-.028
(.016)
-.028
(.016)
-.045
(.064)
-.044
(.066)
-.126
(.141)
-.166
(.139)
--.173
(.318)
.115
(.323)
Industry
Dummies
R2
N
No
.022
336
Yes
.097
336
No
.061
333
Yes
.205
333
No
.052
330
Yes
.174
330
Sources: See Table 1 for source of stock returns. Machinery and equipment share is from the footnote of the
annual report for each company. Rate of investment and net capital stock are from COMPUSTA T. Average tax rates
and predicted changes in cash flow are from Tax Analysts (1985, 1986) and COMPUSTA T.
aThis table shows results of OLS estimation of equation (2) in the text. The dependent variable is the sum of the
excess returns from the House of Representatives and Senate Finance Committee votes. The independent variables
are the share of machinery and equipment in the gross capital stock, the average rate of investment, the net capital
stock (in millions of dollars), the pre-reform average tax rate, and the predicted change in cash flow as a percent of
total value of equity. The industry dummy variables are the same as in Table 1. Industry estimates are not reported.
The final column reports the sample size for the estimate. Firms were omitted from longer period regressions when
newspapers reported significant nontax news (generally merger activity) in the period. Standard errors are in
parentheses.
costs are small. The estimates of this differential using 10-day and one-month returns
(0.03 to 0.08 percent) are thus in line with
the Auerbach results."9
In contrast to the equipment share and
investment rate effects, however, there is no
evidence that either average tax rates or pre-
19These estimates suggest two additional points about
the asset price model. First the size of the equipment
share coefficient implies a much shorter adjustment
period than previous studies have found. In the investment function associated with these adjustment costs,
Auerbach's 0.07 estimate suggests that the rate of investment increases by 2 percent for a 1-point increase in
Tobin's q; the estimates of Summers, 1981, in contrast,
are of an increase of 0.031 in the investment rate (see
Huntley Schaller, 1987, for larger estimates of the responsiveness to q). Second, the results imply that increases in the value of old capital are consistent with
relatively small changes in equilibrium product market
prices. With Cobb-Douglas production functions and a
capital share of 25 percent, the output of equipment-only
firms would have to increase in price by just 1.5 percent
more than the output of structures-only firms to produce the 6 percent windfall.
dicted changes in future tax payments affect
excess returns. The latter result is particularly surprising. Under both approaches,
measures of changes in cash flow should be
positively related to excess returns; this coefficient is generally negative and insignificant, however. Similarly, the coefficient on
the average tax rate provides little evidence
for windfall gains from more effective shielding of future liabilities.
These results are quite robust. Replacing
the cash flow change with the change in the
average tax rate, to eliminate potential tax
base problems, does not affect the estimated
coefficients. Further, the estimates change
little when measures of explicit tax provisions such as minimum tax payments are
included in the regression separately or in
tandem with the cash flow variable.20
20An alternative hypothesis about the tax variables is
that, due to incomplete foreign tax credit utilization,
firnmswith large foreign tax payments (essentially min-
VOL. 78 NO. 5
CUTLER: TAXREFORMAND THE STOCK MARKET
1115
TABLE3-THE CORRELATION
OFEXCESS
RETURNSa
May 5
May 6
May 7*
May 8
May 9
May 12
Dec 16
Dec 17
Dec 18*
Dec 19
Dec 20
Dec 23
0.115
(0.056)
-0.045
(0.057)
-0.208
(0.054)
-0.005
(0.057)
0.050
(0.057)
- 0.076
(0.057)
0.027
(0.057)
0.002
(0.057)
-0.044
(0.057)
-0.022
(0.057)
-0.005
(0.057)
0.057
(0.057)
0.104
(0.056)
0.036
(0.057)
0.036
(0.057)
0.168
(0.055)
0.097
(0.056)
0.121
(0.056)
-0.071
(0.057)
0.176
(0.055)
0.124
(0.056)
-0.003
(0.057)
0.087
(0.056)
- 0.022
(0.057)
- 0.002
(0.057)
-0.019
(0.057)
0.055
(0.057)
0.022
(0.057)
-0.018
(0.057)
0.036
(0.057)
-0.014
(0.057)
0.036
(0.057)
-0.071
(0.056)
0.026
(0.057)
0.021
(0.057)
0.004
(0.057)
Source: See Table 1.
aThis table shows correlation of excess returns for the days around the two tax votes.
Sample size is 310 firms for all correlations. The excluded firms had missing return data
for one or more days. The first day after the vote is indicated with an asterisk. Standard
errors are in parentheses.
One final point about Table 2 is troubling
as well. The immediate reaction to tax news,
shown in the first two rows of the table,
cannot be explained by any of the firm characteristics included. All of the estimated coefficients are small in magnitude and statistically insignificant. The same is true when
returns on the day before the evening vote
are utilized as the dependent variable. At
short horizons, returns seem unrelated to the
tax news. I take up some implications of this
puzzle next.
V. GeneralTests of the MarketResponse
The cross-sectional results are consistent
with two hypotheses: either tax reform had
large effects that are not captured by the
included variables; or the news of major tax
reform did not significantly affect market
ing and oil companies) have much greater tax bases
than firms with only U.S. tax liabilities, so that their
cash flow projections are understated relative to the
other firms. Further, given the large changes in world
commodity prices, the effective capital stocks for these
firms might be farthest from market value. Re-estimating the equations without these firms, or including the
ratio of foreign taxes to total taxes paid as a proxy for
these understatements however, does not change the
results.
valuations. This section explores these possibilities.
As a first test of the importance of tax
news, Table 3 presents correlations of excess
returns for the two votes. If tax news had a
large impact on the market, returns on days
of similar news release should be positively
correlated. Table 3 provides little evidence of
large tax effects. The correlation on the days
immediately after the votes is only 0.036,
with a standard error of 0.057. This result is
striking; on the two most important days in
the process of tax reform, stock returns show
no indication of common movement. Other
days show a larger correlation than this, but
there is little evidence of a pervasive reaction
to tax news.21
Over a 10-day horizon, the results are
more promising but still rather weak. The
correlation of 10-day excess returns is 0.197,
with a standard error of 0.055. While this
estimate is statistically significant, it does
not indicate when in the period the adjust-
21One potential explanation for these results is that
the 8i coefficients in equation (1) were changed by the
tax reform, and thus the residuals reflect both tax
reform news and errors from the change in the covariance. When correlations are estimated using either nominal returns or industry stock returns, where the P3iseem
less likely to change greatly, however, the same pattern
of correlations results.
1116
THE A MERICAN ECONOMIC RE VIE W
ment occurred. Indeed, the within-week correlation of excess returns, like the cross-event
correlations in Table 3, are generally very
small.
A second test of the response to tax reform is the dispersion of excess returns
around the tax votes. If tax reform news was
a large part of the market movement, measures of the dispersion of returns on these
days should be greater than similar measures
on non-news days. This does not appear to
be the case, however. The average standard
deviation of returns in the weeks of the two
votes are 1.81 percent for the House vote
and 1.74 percent for the Senate Finance
Committee vote. For the 30 days prior to
May 1986, a period of no consistently large
tax or other news, the average standard deviation is 1.93 percent. Even on the days immediately after the votes, both standard deviations are only 1.96 percent, slightly above
the longer period average.
The same finding is true with oneweek returns. The Monday-to-Monday return standard deviations are 3.54 percent
and 4.01 percent for the two votes, while for
the 14 weeks prior to May 1986, the average
is 4.41 percent.
There findings are consistent with two
possibilities about market expectations of tax
changes. Unfortunately, however, neither
possibility seems very plausible. First, the
events considered might not have changed
the expectations of market participants. The
long discussions of the tax bill in Congress,
or the support for tax reform by President
Reagan might have convinced investors that
tax reform was soon to occur. Both the immediate attention paid to the votes and the
chronicles of journalists who covered the
bill's progress (Jeffrey Birnbaum and Alan
Murray, 1987), however, make it difficult to
believe that tax reform was anticipated long
in advance.
Second, the importance of the tax bill
might have been reduced because further tax
changes were expected after this bill passed.
If, for example, investors felt that the bill
would be quickly repealed or that tax rates
would return to their previous levels soon,
the reaction to the tax news would not be
large. Evidence for this explanation is found
DECEMBER 1988
in the statements of congressmen who had
hoped to raise revenue from the tax bill, and
in the newspaper articles that cautioned
against accepting this as the last major tax
change. Again, however, the length of the
process seems to belie the hypothesis of quick
tax revisions.
VI. Conclusions
The stock market response to the 1986
Tax Act suggests a mixed conclusion about
the impact of tax reform. First, there is some
microeconomic evidence for the predictions
of the asset price model of incidence. The
revaluation of share prices from the differential taxation of new and old capital and
the reduced value of existing depreciation
allowances do appear to be empirically important. Second, however, there is little evidence of positive responses to changes in
cash flows, or of significant reactions to the
tax news more generally. Tests of the variances and covariances of excess returns consistently reject the hypothesis of large, immediate changes in share values. Further, plausible explanations for the small response do
not appear to be consistent with the tax
reform process.
These latter results especially suggest that
an explanation for the observed reaction may
be inefficient pricing of the tax news by
the market. Recent evidence indicates that
changes in macroeconomic fundamentals
cannot explain much of the variation in stock
returns, and that even large legislative and
diplomatic events that are not captured in
macroeconomic time-series cannot account
for a significant part of the residual variation
(David Cutler, Poterba, and Summers, 1988).
The limited reaction to the tax news could
thus be indicative of this more general inexplicability of stock returns with economic
fundamentals.
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VOL. 78 NO. 5
CUTLER: TAX REFORM AND THE STOCK MARKET
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_