Abstract

The tax burden on equity securities has varied substantially since US federal income taxes were introduced in 1913. Taxes on equity securities vary over time due to changes in dividend and capital gains tax rates and due to changes in corporate payout policies. Equity taxes also vary across firms due to persistent differences in propensities to pay dividends. Despite the continu-ing policy debate on the level of dividend and capital gains taxes, there is a paucity of evidence regarding the effects of tax changes on equity valuations. This study investigates empirically whether changes in investment tax rates had an impact on US equity prices over the period between 1913 and 2006. My paper contrasts two hypotheses of whether taxes are capitalized into equity valuations. Under the tax capitalization hypothesis, aggregate equity valuation measures are inversely related to the tax burden on equity securities. In this case, an increase in investment tax rates reduces the valuation of equity securities generating higher expected before-tax returns. The higher expected returns compensate taxable investors for their increased tax burden. Thus, aggregate equity valu-ation levels should be relatively low during time periods when investment taxes are high. In contrast to the tax capitalization hypothesis, Merton H. Miller and Myron S. Scholes (1978) postulate that investment taxes can be avoided in perfect capital markets and that the marginal Tax Changes and Asset Pricing