Capital gains taxation and the cost of capital

Harry Huizinga, Johannes Voget, Wolf Wagner

31 October 2012



Individuals who sell appreciated shares typically have to pay tax on their capital gains. The US, for instance, currently has a 15% tax on long-term capital gains, which is scheduled to increase to 23.8% in 2013. The average tax rate among OECD countries was 12.6% in 2007.

With tax rates of this magnitude, there is reason for concern that capital gains taxation increases the cost of equity capital for firms. A higher cost of capital in turn reduces private-sector investment and it leads to lower economic growth.

Statutory capital gains tax rates, however, overstate the true burden of capital gains taxation, as in practice private investors pay taxes on their capital gains net of any losses. Consistent with this, Ivković et al. (2005) show that private investors time their losses to reduce their overall tax bill. In addition, institutional investors are exempt altogether from capital gains taxation.

But how much lower is the effective tax rate on capital gains relevant for the cost of capital, compared to the statutory one? In a recent paper (Huizinga et al. 2012), we estimate that the effective tax rate on capital gains amounts to 31.3% of the statutory rate. Thus, the effective tax rate on capital gains in the US would currently be around 4.7%.

Impact on the cost of capital is sizeable

Even at this lower effective rate, capital gains taxation can have a significant impact on the cost of equity capital. Using historical US stock market data, we can calculate that an effective capital gains tax of 4.7% on average reduces the annual, after-tax stock return by 0.38 percentage points. This suggests that the average pre-tax return on US equities has to be 0.38 percentage points higher to compensate investors for their prospective capital gains tax liability. An increase of 0.38 percentage points is substantial in comparison to a historical total return on US stocks of 11.2%, as measured by the S&P 500 Index. An increase in the cost of capital of this size is expected to have a material impact on corporate investment.

How to estimate the impact on the cost of capital?

Capital gains taxation only increases firms’ cost of equity capital if it reduces the prices at which firms can issue new shares. Thus, one needs to assess the impact of capital gains taxation on the pricing of new share issues to infer the impact of capital gains taxation on the cost of capital.

In our paper, we examine the particular case of new share issuance resulting from international mergers and acquisitions. Cross-border takeovers typically result in new equity ownership (by the shareholders of the acquiring firm) of the foreign target firm. Effectively, new equities are issued to the acquiring shareholders. The international takeover price is the price at which the acquiring shareholders are buying these newly issued equities. Considering new equity issues in the context of international mergers and acquisitions has the advantage that we can examine deals involving acquiring firms resident in many different countries, with considerable variation in capital gains tax regimes.

For 5,349 mergers and acquisitions over the 1985-2007 period, we relate the international takeover price to the capital gains tax rate in the country where the acquiring firm resides (and where also acquiring shareholders are presumed to live). A one percentage point higher capital gains tax rate in the acquiring country is found to reduce the international takeover price by 0.225%. This implies a discount of 3.4% in the international acquisition prices paid by US acquiring firms, given the US capital gains tax rate of 15%. The estimated relationship between capital gains tax rates and international takeover prices allows us to infer the impact of capital gains taxation on the cost of capital as implicit in these takeover prices.1

Policy implications

Capital gains taxation significantly increases the cost of equity capital, with potentially negative implications for corporate investment and economic growth. This suggests that the capital gains tax rate should be kept relatively low.

In the international economy, however, countries may have an incentive to impose high capital gains tax rates to ensure that their national acquiring firms get better takeover prices in international deals, as suggested by our research. This is a reason to suspect capital gains tax rates are set too high, and it could motivate international coordination in the area of capital gains taxation to bring them back down.

In the EU context, some coordination related to capital gains taxation already exists in the form of the Mergers and Acquisitions Directive of 1990. This Directive stipulates that equity-financed, cross-border takeovers should not trigger any immediate capital gains taxation at either the corporate or personal level. The purpose of this directive is to ensure that the taxation of capital gains at the time of the takeover does not constitute a barrier to cross-border restructurings. However, this existing directive does not address the incentive that countries currently have to impose high capital gains taxes with a view to lowering acquisition prices in international takeover deals. Some international coordination to address this problem appears desirable as well.


Andrade, G, M Mitchell and E Stafford (2001), “New Evidence and Perspectives on Mergers”, Journal of Economic Perspectives 15, 103-120.
Huizinga, H, J Voget, and W Wagner (2012), “Capital Gains Taxation and the Cost of Capital: Evidence from Unanticipated Cross-Border Transfers of Tax Bases”, CEPR DP 9151.
Ivković, Z, J Poterba and S Weisbenner (2005), “Tax-Motivated Trading by Individual Investors”, American Economic Review 95, 1605-1630.

1 Consistent with research by Andrade et al. (2001), we assume that the overall (net) synergy gains created by the takeover accrue to target-firm shareholders, as reflected in the takeover price.



Topics:  International finance

Tags:  taxation, capital gains, mergers and acquisitions

Professor of Economics and Chairman of the European Banking Centre, Tilburg University

Chair of Taxation and Finance, University of Mannheim

Professor of Economics, University of Tilburg