Capital Gains Taxes and Stock Return Volatility

Transcription

1 Capial Gains Taxes an Sock Reurn Volailiy Zhonglan Dai Universiy of Texas a Dallas Douglas A. Shackelfor Universiy of Norh Carolina an NBER Harol H. Zhang Universiy of Texas a Dallas Firs version: Augus, 006 This version: January, 007 We hank Yexiao Xu for helpful iscussions; Qin Lei, Dave Mauer, Kam-Ming Wan, an seminar paricipans a Baruch College, he Souhern Mehois Universiy, an he Universiy of Texas a Dallas for commens; an Sco Dyreng an Suarshan Jayaraman for research assisance. Zhonglan Dai is a he School of Managemen, Universiy of Texas a Dallas, Richarson, TX 75083, [email protected], Douglas A. Shackelfor is a he Kenan-Flagler Business School, Universiy of Norh Carolina, Chapel Hill, NC 7599, [email protected], an Harol H. Zhang is a he School of Managemen, Universiy of Texas a Dallas, Richarson, TX 75083, [email protected]. All errors are our own.

2 Capial Gains Taxes an Sock Reurn Volailiy Absrac We emonsrae ha capial gains ax changes inversely affec sock reurn volailiy. A capial gains ax cu reuces he risk sharing beween invesors an he governmen an increases sock reurn volailiy. The ax effec on reurn volailiy also iffers epening upon he characerisics of socks such as ivien isribuion an embee capial gains an losses. Using he Tax Relief Ac of 997, we empirically show ha he reurn volailiy of he marke inex, inusry porfolios, an iniviual socks increases afer he capial gains ax cu. Furhermore, higher ivien-paying socks experience smaller increase in reurn volailiy han lower ivien-paying socks an socks wih large embee capial gains an losses see larger increase in reurn volailiy han socks wih small embee capial gains an losses.

3 . Inroucion This paper examines he effec of capial gains axes on asse reurn volailiy. Exising suies on he effecs of capial gains axes on asse prices have primarily focuse on he level of asse reurns an on raing volume. The goal of his suy is o invesigae he relaion beween asse reurn volailiy an capial gains axes. We emonsrae ha imposing capial gains axes reuces asse reurn volailiy because he governmen shares he gains an losses in asses hel by invesors subjec o axaion upon realizaion. Our analysis relies on he role of financial markes in faciliaing risk sharing beween invesors an he governmen in he presence of capial gains axes. A capial gains ax cu reuces risk sharing beween invesors an he governmen an has an averse effec on iniviual invesors consumpion smoohing. This leas o a more volaile iniviual consumpion growh rae an sochasic iscoun facor, resuling in a higher asse reurn volailiy. Using he Tax Relief Ac of 997, we uncover srong evience ha a capial gains ax cu significanly increases he volailiy of asse reurns an he magniue of increases in reurn volailiy iffers epening upon he characerisics of asses such as ivien isribuion, embee capial losses an gains, an he percenage of shares owne by ax sensiive invesors. To our knowlege, his is he firs suy of he relaion beween asse reurn volailiy an he capial gains axes. There is an increasing lieraure abou how capial gains axes affec asse prices. Exising heoreical suies sugges ha he effec of capial gains axes on asse price is likely o be ambiguous because inroucing capial gains axes ecreases boh he eman an he supply of asses. Empirical invesigaions on he effec of capial gains axes have prouce conflicing resuls. Several suies Lang an Shackelfor 000, Ayers, Lefanowicz, an Robinson 003, among ohers repor ha he presence of capial gains axes reuce sock price an curren sock reurn, while oher suies ocumen ha imposing capial gains axes increases sock price an curren sock reurn Felsein, Slemro, an Yizhaki 980, Reese 998, Klein 00, Jin 005, among ohers. Furher, Dhaliwal an Li 006 invesigae he relaion beween invesor ax heerogeneiy an ex-ivien ay raing volume an ocumen a concave relaion beween ex-ivien ay raing volume an invesor ax heerogeneiy measure by

4 insiuional ownership. In a recen suy, Dai, Mayew, Shackelfor, an Zhang 006 invesigae he effec of capial gains axes on asse price an raing volume by joinly consiering he impac on eman an supply of asses. Using he Taxpayer Relief Ac of 997 as he even, hey fin ha sock reurns are higher in anicipaion of a ax cu an socks wih large embee capial gains an high ax sensiive invesor ownership experience a lower reurn afer he lower ax rae became effecive. They also ocumen ha a capial gains ax cu increases he raing volume he week before an immeiaely afer he ax cu announcemen. However, none of he exising suies has examine he relaion beween asse reurn volailiy an capial gains axes. Asse reurn volailiy is one of he key eerminans of invesors eman an supply of risky asses. If he presence of capial gains axes affecs asse reurn volailiy, i will cerainly impac invesors eman an supply of risky asses an ulimaely influence asse reurns. In his paper, we firs iscuss he relaion beween he capial gains axes an asse reurn volailiy focusing on he risk sharing role of he capial gains axes beween invesors an he governmen. Base on our analysis, we evelop hypoheses on he relaion beween he capial gains axes an asse reurn volailiy. We hen empirically es he preicions using he Taxpayer Relief Ac of 997 as our even. Overall, our analysis suggess he following esable implicaions when he capial gains ax rae is reuce. Reurn volailiy is increase for he marke inex, inusrial porfolios, an iniviual socks. Higher ivien-paying socks wih high ax sensiive invesor ownership will experience lower volailiy increase han lower ivien-paying socks. Socks wih large embee capial gains losses an high ax sensiive invesor ownership will have higher volailiy increase han socks wih small embee capial gains losses. The firs preicion focuses on he effec of a capial gains ax cu on he reurn volailiy of porfolios an he marke inex. Thus, i represens he effec of a capial gains ax cu on he volailiy of he broa financial marke. The nex wo preicions focus on he effec of a capial gains ax cu on iniviual sock reurn volailiy an 3

5 consiue he cross-secional implicaions of a capial gains ax cu on iniviual sock reurn volailiy. Our preicions are closely relae o he roles playe by he financial markes. From invesors perspecive, financial markes have wo imporan funcions: risk sharing an consumpion smoohing. In aiion o acively sharing risk wih oher marke paricipans, in he presence of he capial gains axes, invesors also share he risk of holing risky socks wih he governmen passively. This is clearly exemplifie when he invesors asse holings have epreciae in value. In his case, he invesors ne losses are less han he ecrease in he marke value of he asse because a fracion of he loss is borne by he governmen in he form of reuce capial gains axes or even ax rebae from he governmen. When he capial gains ax rae is cu, risk sharing beween invesors an he governmen is reuce. Invesors hus experience more volaile consumpion growh raes resuling in increase volailiy for he sochasic iscoun facor. This hen leas o an increase in sock reurn volailiy. Because he risk sharing role associae wih he capial gains axes varies wih socks wih ifferen characerisics, he impac of a capial gains ax change on sock reurn volailiy also iffers corresponingly. Ceeris paribus, lower- an non-ivien paying socks are riskier an will hus experience larger increases in reurn volailiy han higher ivienpaying socks afer he capial gains ax rae is reuce. Socks wih larger embee capial gains an losses become riskier when he capial gains ax rae is lower because here is less risk sharing wih he governmen. These socks will experience higher volailiy increases. Our empirical analysis on sock reurn volailiy surrouning he 997 capial gains ax rae cu provies srong suppor for our preicions on he effec of he capial gains ax change on sock reurn volailiy. For he marke porfolio, we fin he volailiy of monhly excess reurn of he value-weighe CRSP socks is more han 3 percen higher when he capial gains ax rae is reuce from 8 percen o 0 percen, afer conrolling for several variables which are wiely ocumene o be imporan eerminans of sock reurn volailiy an he sae of he economy. Furher, for five inusry porfolios forme base on 4-igi SIC coe incluing consumer inusry, manufacuring inusry, high ech inusry, healhcare inusry, an oher inusries, he 4

6 monhly reurn volailiy is higher for all five porfolios when he capial gains ax rae is reuce, conrolling for variables ofen ienifie o be imporan facors affecing reurn volailiy. The increase in monhly reurn volailiy ranges from.3 percen for he healhcare inusry o 5 percen for he high ech inusry. In aiion, he increase in reurn volailiy for all five inusries is saisically significan wih four inusries having p-value less han percen an one inusry p-value of For iniviual firms, we fin ha sock reurn volailiy is higher on average afer he capial gains ax rae cu, lening suppor o he resuls on he marke inex an inusry porfolios. Higher ivien-paying socks wih large ax sensiive invesor ownership experience lower volailiy increase han lower ivien-paying socks, consisen wih he preicion of our analysis. The fining is primarily concenrae on ivien-paying socks ha experience sock price ecline in he pas 8 o 36 monhs. Socks wih large embee capial losses an high ax sensiive invesor ownership show much larger volailiy increase han average socks afer he capial gains ax rae cu. For insance, every hing else he same, for a 50 percen aiional loss, he monhly iniviual sock reurn volailiy is higher by. o.8 percen when he ax sensiive ownership is measure by he percenage of shares owne by iniviual invesors an iniviual invesors an muual funs, respecively. We also fin ha socks wih large embee capial gains experience higher volailiy increase. Furher, his fining is sronger for non-ivien paying socks han for ivien-paying socks. For insance, for non-ivien paying socks wih a 50 percen aiional gain, he monhly iniviual sock reurn volailiy is higher by 0.44 o 0.69 percen for he wo measures of ax sensiive ownership, respecively. Our finings are robus o alernaive measures of embee capial gains an losses, he inclusion of iverse growh opions for ifferen iniviual firms, an he subperio excluing observaions in year 000 an year 00 uring which he sock marke experience significan ecline. I is worh noing ha he sock reurn volailiy increase associae wih a capial gains ax cu oes no necessarily imply ha invesors are worse off when he capial gains ax rae is lower. This is because a capial gains ax cu may increase he afer-ax sock reurn. Consequenly, invesors may experience he same or improve reurn an risk rae-off an hus face he same or beer invesmen opporuniies. 5

7 The paper is organize as follows. In secion, we iscuss he mechanism ha he capial gains axes affec sock reurn volailiy an evelop hypoheses on he effecs of a capial gains ax cu on reurn volailiy boh for marke inex an inusry porfolios an he cross-secion of iniviual socks. Secion 3 presens empirical mehoology o es he preicions of our analysis. Secion 4 iscusses he resuls of he empirical analysis. Conclusion remarks are provie in Secion 5. In he appenix, we presen a ynamic moel wih capial gains axes o erive esable implicaions on sock reurn volailiy when he capial gains ax rae is change.. Capial Gains Taxes an Sock Reurn Volailiy Financial markes an he financial asses rae in hose markes serve wo imporan roles for invesors: consumpion smoohing an risk sharing. Some iniviuals earn more han hey currenly wish o spen, while ohers spen more han hey currenly earn. Financial asses allow hese iniviuals o shif heir purchasing power from highearnings perios o low-earnings perios of life by buying financial asses in high-earning perios an selling hese asses o fun heir consumpion nees in low-earning perios. Financial markes an he financial asses also allow invesors o allocae risks among hemselves so ha risk in heir porfolio is commensurae wih he reurn o he porfolio, i.e., invesors wih high risk olerance hol riskier asses such as socks an hose wih low risk olerance hol more less risky asses such as money marke insrumens. In an economy wihou governmen axaion, consumpion smoohing an risk sharing are achieve among marke paricipans hrough raing of financial asses on financial markes. In he presence of axaion, he governmen, however, plays an imporan role in influencing he consumpion smoohing an risk sharing among marke paricipans. Capial gains axes in paricular have a large impac on consumpion smoohing an risk sharing of invesors paricipaing in he financial markes an financial asse raing. In he Unie Saes, capial gains axes are levie upon selling an asse base on he appreciaion or epreciaion on he asse. Specifically, in he case of common socks, if a sock has appreciae in value, he invesor pays capial gains axes on he appreciaion upon selling. On he oher han, if he sock has epreciae in value upon selling, he 6

8 invesor can use he realize losses o offse realize gains on oher asses. If he realize losses excee he realize gains, he losses can be use o reuce he axable orinary income up o a limi wih he remaining losses carrie forwar o offse fuure gains an orinary income. The ax reamen of he gains an losses on socks hus offers a risk sharing mechanism beween invesors an he governmen. Consequenly, he capial gains axes will affec he consumpion smoohing of sock marke paricipans. The risk sharing beween invesors an he governmen associae wih he capial gains axes will ulimaely affec he sock reurn volailiy. Uner no arbirage coniion, Harrison an Kreps 979 emonsrae ha here exis sochasic iscoun facors ha can be use o price he sochasic payoffs associae wih any asses. Subsequenly suies have suggese ha he sochasic iscoun facors or pricing kernels can ake ifferen specificaions epening upon invesors preferences, consumpion profiles, an various forms of marke fricions, among ohers. In paricular, recen suies sugges ha he consumpion growh rae of sock marke paricipans is an imporan eerminan of sochasic iscoun facors Mankiw an Zeles, 99, Jacobs, 999, an Brav, Consaninies, an Geczy, 00, among ohers. In general, hese suies ocumen ha he sochasic iscoun facor using he more volaile consumpion growh raes for sockholers explains he volaile sock reurns beer han he aggregae consumpion growh rae. This suggess a posiive relaion beween he volailiy of he consumpion growh rae an he sock reurn volailiy. Because he capial gains axes affec he risk sharing beween invesors an he governmen an he consumpion smoohing of sock marke paricipans, he change in he capial gains axes will impac he volailiy of he consumpion growh raes of hese invesors an consequenly he sock reurn volailiy. To faciliae he evelopmen of our hypoheses on he relaion beween he capial gains axes an sock reurn volailiy, we focus on some exreme cases an hen offer insighs on general siuaions. We sar wih he effec of he capial gains axes on he broa financial marke an hen iscuss he cross-secional implicaions of a change in he capial gains axes on iniviual sock reurn volailiy. Our iscussions above sugges ha he governmen serves as a parner in sharing he reurn of sock invesmens wih he axable invesor parner in he presence of he capial gains axes. Suppose he capial gains ax rae is close o 00 percen. The governmen parner hus ges almos all he 7

9 reurns of invesmens mae by axable invesors. Consequenly, i bears almos all he risk while he risk borne by axable invesors is negligible. On he oher han, suppose ha he capial gains ax rae is 0. Then he axable invesor parner receives all he reurns an bears all he risk. In realiy, he capial gains ax rae is ypically posiive bu below 00 percen. When he capial gains ax rae increases, he governmen parner receives a larger fracion of he reurn an bears more risk. The axable invesor parner receives a lower fracion of he reurn an bears less risk. When he capial gains ax rae is reuce, however, he governmen parner ges a smaller fracion of he reurn an bears less risk while he axable invesor parner receives a larger fracion of he reurn an bears more risk. Because capial gains axes apply o all socks, in he case of a capial gains ax cu, axable invesors will receive a larger fracion of reurns on all socks an bears more risk on all he socks, leaing o a more volaile consumpion growh raes for hese invesors. As a resul, we have he following hypohesis on he relaion beween he capial gains axes an he reurn volailiy for he broa sock marke. H: A capial gains ax cu will lea o a higher reurn volailiy for he marke inex, inusry porfolios, an iniviual socks. Because ifferen socks have ifferen ax liabiliies an invesor bases, a capial gains ax change will have ifferen impac on risk sharing beween invesors an he governmen. Firs, firms wih ifferen ivien payous will likely have ifferen impac on he risk sharing beween axable invesors an he governmen in he case of a capial gains ax cu. Imagine ha axable invesors receive all reurns from a firm as iviens. In his case, no income receive is subjec o capial gains axes. Consequenly, he governmen bears no risk relae o capial gains or losses an he capial gains axes will have lile irec effec on he volailiy of he sock reurn. On he oher han, if he axable invesors receive no iviens an he enire reurn is in he form of capial gains, all income will be subjec o capial gains axes an he governmen bears he maximum risk associae wih he capial gains. In his case, a capial gains ax change will have a large effec on he risk sharing beween he axable invesors an he governmen an he consumpion growh rae of he axable invesors. Consequenly, i will have a large impac on he sock reurn volailiy. In general, he more he capial gains ax or he less 8

10 he ivien ax is levie on he firm s profis, he more he governmen shares in he risk. A capial gains ax change will have a larger effec on he risk sharing an he consumpion growh raes of axable invesors. This leas o he following hypohesis on he relaion beween he iniviual sock reurn volailiy an he ivien payous of hese firms. H: A capial gains ax cu will increase he reurn volailiy of lower ivienpaying socks more han ha of higher ivien-paying socks. Secon, firms wih ifferen embee capial gains or losses will also have ifferen effec on he risk sharing beween axable invesors an he governmen in he case of a capial gains ax cu. Suppose ha he sale procees of a axable invesor in a sock are equal o he axable invesor s ax basis he cos of purchasing he sock. The invesor woul have no income subjec o capial gains axes upon realizaion because he embee gain or loss is zero. The governmen also bears no risk. However, if he invesor s sale procees are equal o he gains he cos of purchasing he sock is almos zero relaive o he sale procees or he invesor s sale procees are almos zero he loss is equal o he cos of purchasing he sock, all income are subjec o he capial gains axes or all losses can be use o reuce ax liabiliies firs realize capial gains an hen orinary income. In his case, he governmen bears he maximum risk. A capial gains ax change will have a large impac on he risk sharing an consumpion smoohing of he axable invesors on hese socks. The effec of a capial gains ax change will also be large on he reurn volailiy of hese socks. We herefore have he following hypohesis on he relaion beween sock reurn volailiy an embee capial gains or losses in he case of a capial gains ax cu. H3: A capial gains ax cu will increase sock reurn volailiy of firms wih large embee capial gains losses more han ha of firms wih small embee capial gains losses. In he appenix, we presen a ynamic economic moel wih capial gains axes o erive he implicaions for sock reurn volailiy in he case of a capial gains ax cu. For racabiliy, we assume here are wo socks. One pays higher ivien han he oher. Capial gains an losses are realize every perio. Uner cerain coniions, we show ha he reurn volailiy of all socks, consequenly he marke inex, increase when he 9

11 capial gains ax rae is reuce. Furher, he volailiy increase is smaller for he higher ivien-paying sock han for he lower ivien-paying sock. The preicions are consisen wih our hypoheses H an H iscusse above. In he nex secion, we iscuss empirical mehoology o es hree hypoheses iscusse above. 3. Empirical Mehoology To empirically es he effec on sock reurn volailiy of a change in he capial gains ax rae, we use he Taxpayer Relief Ac of 997 TRA97 as our even. The TRA97 lowere he op ax rae on capial gains from 8 percen o 0 percen for asses hel more han 8 monhs. TRA97 is paricularly aracive for an even suy because he ax cu was boh large an relaively unexpece. Ofen ax legislaion follows a prorace process wih graual changes in he probabiliy of a paricular bill becoming a law. In TRA97, however, Congress provie researchers wih an aracive seing by coming o rapi agreemen on a large, relaively unexpece reucion in capial gains ax raes. For he Taxpayer Relief Ac of 997 TRA97, lile informaion was release unil Wenesay, April 30, 997, when he Congressional Buge Office CBO surprisingly announce ha he esimae of he 997 efici ha been reuce by $45 billion. Two ays laer on May, he Presien an Congressional leaers announce an agreemen o balance he buge by 00 an, among oher hings, reuce he capial gains ax rae. These announcemens grealy increase he probabiliy of a capial gains ax cu. On Wenesay, May 7, 997, Senae Finance Chairman William Roh an House Ways an Means Chairman William Archer joinly announce ha he effecive ae on any reucion in he capial gains ax rae woul be May 7, 997. The empirical implicaions we erive above apply no only o he broa financial marke, hey also apply o iniviual socks. In our empirical analysis, we firs examine reurn volailiy a marke level using he value-weighe marke inex, we hen move own o inusry level using five inusry porfolios incluing consumer, manufacuring, high ech, healh, an ohers, classifie base on 4-igi SIC coe, an finally we examine reurn volailiy of iniviual socks. A each level, we use aily reurns o consruc monhly volailiy measure. For he es on he reurn volailiy of he marke an inusry porfolios, he sampling perio is from January 993 o December 0

12 00. For he es on iniviual sock reurn volailiy, he ime perio we use in our baseline case is from //994 o /3/00. We also perform a robusness check on iniviual sock reurn volailiy using a shorer subsample ha ens a /3/999 o exclue he perio of significan marke ecline in year 000 an 00. To avoi he ransien effec cause by he capial gains ax cu announcemen, we exclue April an May of 997 from our analysis. The capial gains rae reucion in he TRA97 is only applie o income ha is repore on personal ax reurns, i.e., capial gains from he selling of shares hel irecly by iniviuals or hel inirecly by iniviuals in flow-hrough eniies, such as muual funs, parnerships, russ, S corporaions, or limie liabiliy corporaions ha pass income o invesors personal ax reurns. Capial gains axes are no levie on axeferre accouns e.g., qualifie reiremen plans, incluing pensions, IRAs an 40k, ax-exemp organizaions, an foreigners. Corporaions pay capial gains axes; however, he rae reucion in TRA97 i no apply o corporaions. Thus, our empirical ess, especially a he iniviual sock level, will be base on he amoun of holings by ax sensiive invesor ownership, such as iniviual invesors an/or muual funs. To capure he group of invesors who are he mos sensiive o he capial gains axes, we consruc proxies for he percenage of ax sensiive invesor ownership of a sock iniviual invesors an/or muual funs using aa on shares ousaning an shares owne by insiuional invesors. The aa on he insiuional invesors ownership are obaine from heir quarerly filings wih he U.S. Securiies an Exchange Commission known as Form 3F. Le rij be he reurn on sock or inusry i on ay j in monh anσ be sock or inusry i s reurn volailiy in monh. We consruc he monhly sock or inusry reurn volailiy for each firm-monh or inusry-monh as follows J σ = r r, i j= ij i i We have also performe our analysis by excluing June, July, an Augus in aiion o April an May o accoun for he acual signing of he ax cu bill. The resuls are qualiaively similar.

13 where r i = J J r ij j= is he sample mean reurn for sock or inusry i in monh, he number of observaions in monh. For he marke inex, we consruc he monhly marke reurn volailiy for each monh, σ, as follows J J rj r j= j= σ = r r r r, j j J is where rj is he marke excess reurn on ay j of monh an r = J J r j j= is he sample mean excess reurn for he marke inex in monh. Noe ha he marke reurn volailiy hus efine incluing he exra cross-prouc erms in he expression ajuss for he firs-orer auocorrelaion in aily reurns associae wih nonsynchronous raing among socks inclue in he inex. The research esign we use o es our hypoheses on he change in sock reurn volailiy in response o he capial gains ax cu is o efine a ummy variable Pos which akes value 0 before 3/3/997 an value afer 6//997. Noe ha his is ifferen from sanar even suy on sock reurns which focuses on announcemen effec. We acually ake ou hose even monhs from our examinaion because we are inerese in he change of volailiy level before an afer he even. Anoher imporan ifference beween sock reurn an he volailiy of sock reurn is ha he laer has significan persisence which may cause problems in he saisical inference if no appropriaely accoune for. To allow for he serial correlaion in sock reurn volailiy, we use lagge emeane volailiy as explanaory variable in our analysis. Specifically, he specificaion we use for marke inex is: p σ = α β Pos ρ j σ j δ jr j γ ' X ε, j= q j= 3 where T σ = σ σ k is he emeane volailiy measure for he marke inex an T k= subscrip j refers o is lags. Exising empirical asse pricing suies sugges ha large Similar measures are use in French, Schwer an Sambaugh 987 an Guo an Whielaw 006, among ohers.

14 negaive sock price changes en o be followe by perios of high sock reurn volailiy. In oher wors, sock reurn volailiy is asymmeric in sock reurn performance. This is someimes referre o as he leverage effec. To accoun for his effec, we allow sock reurn volailiy o epen on lagge sock reurns r j. Finally, X refers o a vecor of aggregae conrol variables an hey inclue he consumpionwealh raio CAY, he sochasically erene risk free rae RREL, an he inusrial proucion growh rae GIP. Base on he capial asse pricing heory, Leau an Luvigson 00 propose ha he consumpion-wealh raio be use as a eerminan for sock reurns. They furher emonsrae ha he CAY variable is a beer preicor han he ivien yiel, he erm premium, he efaul premium, an oher previously wiely use preicors combine. Campbell an Shiller 988 ocumen ha he sochasically erene risk free rae is an imporan preicor for sock reurns. We also inclue he growh rae of he inusrial proucion o accoun for he sae of he economic aciviies. For each inusry porfolios i, we use he following specificaion: p σ = i α β Pos ρ j σ j δ jr j θ j σ i j η jri j γ ' X ε i. j= q j= 4 Noe ha, in aiion o he explanaory variables inclue in he specificaion for he marke inex, we have also inclue lagge emeane inusry porfolio volailiy σ an lagge inusry porfolio reurns ri j o accoun for volailiy i j persisence an leverage effec a inusry level. For iniviual socks, we firs es he across boar effec on iniviual sock reurn volailiy associae wih a capial gains ax cu. This is achieve by applying specificaion 4 o he reurn volailiy of iniviual socks. We hen exen he specificaion o joinly es he across boar effec an he cross-secional effec on iniviual sock reurn volailiy associae wih a capial gains ax cu. We consier wo specificaions for he join es for he across boar effec an he cross-secional effec on he reurn volailiy of iniviual socks. Firs, we consier he following moel we refer o i as he basic join specificaion: m j= n j= 3

15 σ i = α β Pos λ Pos Losses λ Pos Yiel i TSO i i TSO 3 i λ Pos Gains i TSO i 5 p j= ρ σ j j q j= δ r j j m j= θ σ j i j n j= η r j i j γ ' X ϕ' Z i ε. i The specificaion is more complex relaive o he above wo an allows us o es no only he across boar effec of a capial gains ax cu on sock reurn volailiy, bu also he ifferenial ax effec across ifferen socks. In aiion o he ummy variable for he perios afer enacmen of TRA97 Pos his specificaion also inclues ineracions o es he cross-secional effec of a capial gains ax cu on iniviual sock reurn volailiy. Specifically, we inclue he ineracion of he ummy variable Pos wih he ivien yiel Yiel i an he ax-sensiive ownership TSO i o es if higher ivien-paying socks wih large ax-sensiive ownership experience lower reurn volailiy increase han lower ivien-paying socks afer he capial gains ax cu. We also inclue he ineracion of he Pos ummy wih he embee capial loss Losses i an ax-sensiive ownership, an he ineracion wih he embee capial gains Gains i an ax-sensiive ownership o es if firms wih larger embee capial losses gains an high ax-sensiive ownership experience higher reurn volailiy increase afer he capial gains ax cu. The Gains an he Losses are measure base upon he sock price change appreciaion or epreciaion in he pas 8 monhs up o he mos recen pas monh prior o in our baseline case. 3 Specifically, Gains i is sock i s embee capial gains if he sock price change is posiive an akes value of 0 oherwise, Losses i is sock i s embee capial losses if he sock price change is negaive an akes value of 0 oherwise. The ax-sensiive invesor ownership TSO i is measure as he percenage of shares owne by iniviual invesors an/or muual funs he wo groups affece by he TRA97. In aiion o all he conrol variables we use in he equaions for he reurn volailiy of he marke inex an inusry porfolios, we have also inclue a vecor of aiional firm level ineracion erms as of ime. Z i which consiss of firm-specific characerisics an 3 We also perform our empirical es using gains an losses measure a monhs, 4 monhs, an 36 monhs in robusness check. 4

16 In our secon specificaion for he join es of he across boar effec an he cross-secional effec, we exen he basic join specificaion by allowing he relaion beween he reurn volailiy an he ivien yiel o iffer across socks wih embee gains an socks wih embee losses. We also allow he relaion beween he reurn volailiy an he size of embee gains an losses o iffer across ivien-paying socks an non-ivien paying socks. We provie he exene moel for he join es of he across boar effec an he cross-secional effec below we refer o i as he exene join specificaion: σ = α β Pos i φ Pos Yiel 4 5 p j= j φ Pos Gains φ Pos Gains ρ σ φ Pos Yiel j i i i q j= TSO TSO TSO δ r j j i i i i m j= TSO DL Div j i NDiv θ σ i i i i j DG 3 n j= i φ Pos Losses η r j i j i γ ' X TSO ϕ' Z i i ε, 6 where he embee capial gain loss ummy DG i DL i akes value of if he i sock has an embee gain or Gains 0 loss or Losses 0 an akes value of i > i < 0 oherwise, an he ivien isribuion ummy Div i akes value of if sock i isribues iviens in prior year an 0 oherwise, an he non-ivien isribuion ummy NDiv i is efine as [ Div i ]. In a recen paper on sock reurn volailiy, Campbell, Leau, Malkiel, an Xu 00 ocumen ha over he perio from 96 o 997 here has been a noiceable increase in firm-level volailiy relaive o marke volailiy. 4 They sugges several facors as possible explanaions. These facors inclue changing iscoun raes, a shif owars reliance on exernal as oppose o inernal capial markes, firms growh poenials, changes in execuive compensaion, firms leverage posiion, an he increase share of insiuional ownership. Cohen, Hall, an Viceira 000 fin he changes in execuive compensaion have saisically significan effec on he risks of heir firms aciviies. Bu he effec is small in magniue. Gompers an Merick 00 an Xu an Malkiel 4 Similar resuls are also ocumene in Pasor an Veronesi 006 for he more recen perios unil 00. 5

17 003 ocumen ha insiuional ownership increases iniviual sock reurn volailiy. Dai, Mayew, Shackelfor, an Zhang 006 fin ha urnover has a significan effec on sock reurns. Xu an Malkiel 003 an Cao, Simins, an Zhao 006 ocumen ha firms growh opions have significan effec on iiosyncraic risk of equiy. Furher, beween June 997 o Augus 997, boh he New York Sock Exchange an he Nasaq reuce he ick size for sock raing. To capure hese effecs, we inclue eb-asse raio D/A, insiuional ownership in he mos recen pas quarer InsOwn, urnover in he mos recen pas monh Turnover, an he average monhly bi-ask sprea in he mos recen pas monh BiAskSprea for each firm in our firm level reurn volailiy specificaion. As a robusness check we also perform he regression analysis on firm level sock reurn volailiy incluing he forecase operaing income growh rae GrowhOpion as a conrol variable in our robusness analysis in subsecion 4.D. 5 In aiion, we inclue firm size measure in he logarihm of firm s marke capializaion for he mos recen monh Size, NDiv, ivien yiel, embee gains an losses, ineracions Yiel*Gains, Yiel*Losses, NDiv*TSO, NDiv*Gains, NDiv*Losses, Pos*Yiel, Pos*Gains, Pos*Losses, Pos*TSO, Pos*Yiel*Gains, an Pos*Yiel*Losses as oher firm level conrols. Finally for all specificaions, year ummies are use for possible ren an monhly ummies are use o accoun for calenar effec. Our specificaions above consier he effec of capial gains ax rae change on hree ifferen levels of sock reurn volailiy: he marke volailiy, he inusry volailiy, an he firm volailiy. Our iscussion in secion preics ha in he case of a capial gains ax cu sock reurn volailiy generally will be higher afer he lower capial gains ax rae becomes effecive. This implies ha he coefficien β will be posiive for all specificaions represene by equaions 3 o 6. On he cross-secional effec of a capial gains ax cu on iniviual sock reurn volailiy, our analysis preics ha he coefficien for he ineracion Pos Yiel TSO in specificaion 5 will be negaive λ < 0. Our analysis also suggess ha socks wih larger embee capial losses an high ax sensiive ownership will experience higher reurn volailiy increase. This 5 Since he forecase operaing income growh is only available on a small subse of firms, we o no inclue he growh opion variable in he baseline specificaion bu incorporae he growh opion variable in our robusness check. 6

18 implies ha he coefficien for Losses < 0. Pos Losses TSO will be negaive λ < 0 because For socks wih large embee capial gains an high ax-sensiive ownership, our analysis preics ha hey are likely o experience higher reurn volailiy increase. This suggess ha he coefficien for Pos Gains TSO will likely be posiive λ 3 < 0. In he exene specificaion on he join es of he across boar effec an he cross-secional effec of a capial gains ax cu on iniviual sock reurn volailiy equaion 6, he ineracion erms Pos Yiel TSO DG an Pos Yiel TSO DL es if higher ivien-paying firms wih large ax sensiive invesor ownership will experience lower volailiy increase han lower ivien-paying socks afer he capial gains ax cu. The reurn volailiy response is allowe o iffer across socks wih embee gains an losses. Our analysis preics he coefficien for he ineracion erms o be negaive φ < 0 an φ < 0. The coefficien for he ineracion erm Pos Losses TSO will be negaive φ 3 < 0 because Losses < 0. For socks wih embee capial gains, our exene specificaion allows he relaion beween he reurn volailiy an he embee gains o iffer across ivien paying firms an nonivien paying firms o respon ifferenly o a capial gains ax cu. Our analysis in secion suggess ha he coefficiens for boh ineracion erms Pos Gains TSO NDiv an Pos Gains TSO Div will likely be posiive φ 0 an φ > > 4. Empirical Analysis A. Sample an Summary Saisics To empirically es he effec of TRA97 on sock reurn volailiy, we use all socks inclue in he CRSP aa base. The excess reurn on he marke inex is consruce as he marke reurn of he value-weighe porfolio of socks inclue in he CRSP aa base afer he risk free rae is subrace. The five inusry porfolios are forme using he 4-igi SIC coe an consis of consumer inusry consumer urables, non-urables, wholesale, reail, an some services such as launries, repair shops, manufacuring inusry manufacuring, energy, an uiliies, 3 high ech inusry business equipmen, elephone an elevision ransmission, 4 healh care 7

19 inusry healhcare, meical equipmen, an rugs, an 5 oher inusries mines, consrucion, builing maerials, ransporaion, hoels, business services, enerainmen, finance. 6 For he volailiy of marke inex an inusry porfolios, we use he sample from January 993 o December 00 for our regression analysis. For iniviual sock reurn volailiy, he sample use in our regression analysis spans he perio from January 994 o December 00. We choose he sample perio base on wo consieraions. Firs, we wan o avoi he effecs from he ax policy changes boh before an afer he TRA97. Secon, we wan o choose he sample perio so ha we have abou he same observaions before an afer he announcemen. In oher wors, he even monhs fall in he mile of our sample perio. We perform robusness check on iniviual sock reurn volailiy analysis using he subsample aa from January 994 o December 999 o exclue year 000 an 00 when he sock marke experience a large price ecline. For he aggregae conrol variables, we obain he consumpion-wealh raio CAY from Marin Leau s websie. Since he consumpion-wealh raio is a quarerly frequency, we use linear inerpolaion o obain monhly observaions. The sochasically erene risk free rae is consruce by removing he average risk free rae in he prior welve monhs from he risk free rae in monh as in Campbell an Shiller 988. The growh rae of he inusrial proucion is calculae using he monhly inusrial proucion inex obaine from he Feeral Reserve Bank of S. Louis. We obain aily iniviual sock reurn aa from he aily CRSP aa base. Divien an sock price are exrace from he monhly CRSP aa base. The ivien ummy variable Div is consruce base on ivien isribuion in he prior year an akes he value of if he firm isribue ivien an 0 oherwise. We consruc he embee capial gains an losses using a firm s mos recen 8 monh sock price change prior o monh. We hen perform robusness check using monh, 4 monh, an 36 monh price changes o calculae he measure of he embee capial gains an losses. To obain measures of ax sensiive invesor ownership, we use insiuional invesors ownership informaion from Form 3F submie o he Securiy Exchanges 6 The excess reurn on he value-weighe marke inex an reurns on inusry porfolios are obaine from Kenneh French s websie. 8

20 Commission by invesmen managemen companies. 7 We consruc wo measures of he ax sensiive ownership on sock i a ime TSO i as follows: he percenage of iniviual invesor ownership IND i IND i = Percenage of shares owne by insiuional invesors a ime he percenage of iniviual invesor an muual fun ownership IND&MF i IND&MF i = IND i Percenage of shares owne by muual funs a ime. We consruc a firm s eb-asse raio using aa from he COMPUSTAT aa base. Because he COMPUSTAT aa base is only available a quarerly frequency, we assume ha a firm s eb-asse raio remains he same wihin he quarer. Firm size is consruce by muliplying he shares ousaning by per share sock price a monhly frequency. In our regression analysis, we use a fourh-orer polynomial of logarihmic firm size o conrol he effec associae wih firm size. Monhly iniviual sock urnover is consruce by iviing he monhly raing volume by he shares ousaning a he en of he monh. The average monhly percenage bi-ask sprea for iniviual socks is consruce using he ransacion level Trae An Quoe TAQ aa base. 8 For he measure on firms growh poenials, we use he forecase operaing income growh rae on iniviual firms obaine from he IBES aabase as a proxy GrowhOpion. Table presens he summary saisics for variables use in our regression analysis an variable efiniions are a he boom of he able. Panel A repors saisics for he aggregae variables marke inex, inusry porfolios, an economy-wie conrols an panel B repors saisics for iniviual firm variables. The aggregae variables consis of 0 monhly observaions ime series only from January 993 o December 00. The average aily excess reurn for he value-weighe marke porfolio is 0.09 percen wih a sanar eviaion of 0.4 percen. The monhly volailiy of he marke excess reurn has a mean of 4.8 percen wih a sanar eviaion of.3 percen. The inusry porfolios have average aily reurn ranging from 0.03 percen for he manufacuring o percen for he healhcare. The manufacuring inusry has he lowes sanar eviaion of 0.88 percen an he high ech inusry has he highes sanar eviaion of percen. Consisen wih he aily saisics an our inuiion, 7 We hank Rabih Mousssawei for proviing us he insiuional sock ownership aa. 8 We hank Kam-Ming Wan for proviing us he monhly bi-ask sprea aa on iniviual socks. 9

21 he monhly reurn volailiy is he lowes for he manufacuring inusry wih an average of 3.48 percen an a sanar eviaion of.7 percen, an is he highes for he high ech inusry wih an average of 6.88 percen an a sanar eviaion of 3.8 percen. The CAY variable has an average of percen an a sanar eviaion of.08 percen. The sochasically erene risk free rae has a monhly average of percen an a sanar eviaion of 0.07 percen. Over he sample perio, he inusrial proucion grew a 0.8 percen per monh on average wih a sanar eviaion of 0.53 percen. For iniviual firms, he average aily reurn is percen wih a sanar eviaion of 0.77 percen. Boh he average reurn an he sanar eviaion are higher han he corresponing saisics for he inusry porfolios. The monhly reurn volailiy for iniviual socks is 4.43 percen wih a sanar eviaion of.56 percen. The average monhly reurn volailiy for iniviual socks is wice he average monhly reurn volailiy of he mos volaile high ech inusry porfolio percen of he firms pai iviens. The average ivien yiel is.09 percen. The 8 monh sock price change has an average of 9. percen wih a sanar eviaion of 4.5 percen. Iniviual invesors own 6. percen of he shares, on average. Incluing muual fun ownership, iniviual invesors an muual funs ogeher own an average of 73.8 percen of socks. The eb-asse raio for iniviual firms has an average of 0.56 wih a sanar eviaion of 0.3. The average firm size is.46 on he logarihmic scale wih a sanar eviaion of.6. The average urnover for iniviual socks is 8.45 percen wih a sanar eviaion of 4 percen. The average monhly percenage bi-ask sprea is.6 percen wih a sanar eviaion of 3.47 percen. For he subse of firms wih he forecase operaing income growh rae, he average forecase operaing income growh rae for iniviual firms is 4.98 percen wih a sanar eviaion of 7.46 percen. For firm level analysis, we face a common problem associae wih a panel aa base: correlae resiuals among observaions. To ake his issue ino accoun, we use generalize leas squares o esimae our regression moel. Specifically, we use clusere 0

22 sanar error esimaes which are shown o be unbiase in regression analysis using panel aa by Peerson B. Tax effec on reurn volailiy of marke inex an inusry porfolios We begin our iscussion on he effec of a capial gains ax cu on sock reurn volailiy by firs examining he marke excess reurn an he reurn on five inusry porfolios incluing he consumer inusry, he manufacuring inusry, he high ech inusry, he healhcare inusry, an oher inusries. Table repors he regression resuls of equaion 3 on he volailiy of he marke excess reurn column 3 an equaion 4 on he reurn volailiy of five inusry porfolios column 4 o column 8. Consisen wih he preicion of our analysis, he volailiy of he marke excess reurn is higher afer he capial gains ax rae is reuce. Specifically, everyhing else he same, he monhly volailiy of he marke excess reurn is 3.5 percen higher afer he capial gains ax cu han before he capial gains ax cu. This fining is saisically significan a he percen level. For our conrol variables, he lagge consumpion-wealh raio CAY has a significan posiive effec on he marke volailiy. The lagge marke excess reurn has a negaive an significan effec on he reurn volailiy. This is consisen wih he leverage effec which saes ha reurn volailiy is relae o he level of reurns. This negaive relaion also suggess ha reurn volailiy is higher when sock marke performs poorly asymmeric reurn volailiy. For he five inusry porfolios, he esimae coefficien for he ummy variable is consisenly posiive inicaing ha he reurn volailiy is higher afer he capial gains ax cu. Specifically, he monhly reurn volailiy is higher by.79 percen for he consumer inusry,.57 percen for he manufacuring inusry, 5.03 percen for he high ech inusry,.5 percen for he healhcare inusry, an 3.55 percen for all oher inusries afer he capial gains ax cu han before he capial gains ax cu. The volailiy increase is highly saisically significan for four consumer, manufacuring, high ech, an oher inusries ou of five inusries wih a p-value less han percen. For he healhcare inusry, he volailiy increase is significan a convenional 5 percen es level p-value of 3.3 percen for a wo-sie es. The lagge consumpion-wealh 9 We use SAS PROC MIXED proceure o esimae our moels reaing firm as our subjec so ha each firm is one cluser. The gooness of fi for his proceure is given by he - resiual log likelihoo.

23 raio has a significan effec on he monhly reurn volailiy for he consumer, high ech, an he oher inusries a he convenional 5 percen es level. The coefficien esimaes for lagge inusry reurns r i an/or r i are significanly negaive for he consumer, healhcare, an oher inusries a convenional 5 percen es level, an for he manufacuring inusry a 0 percen es level. The resuls sugges ha a negaive sock price change for an inusry will likely be followe by a high reurn volailiy in ha inusry, proviing empirical suppor for he asymmeric reurn volailiy wih respec o lagge inusry reurn. There is also some evience of asymmeric volailiy of inusry reurns wih respec o he marke price change for he manufacuring, he healhcare, an oher inusries as inicae by significan negaive coefficien esimaes for r an/or r. The reurn volailiy of inusry porfolios also exhibi persisence as inicae by he coefficien esimaes for emeane lagge reurn volailiy. For all five inusries he coefficien esimaes for σ i are posiive an significan a he convenional 5 percen level. Monh ummies are no significan a convenional levels inicaing insignifican calenar effec for he volailiy of he marke excess reurn an he volailiy of inusry porfolio reurns. The year ummies are mosly insignifican lening suppor o he fining of no long-run evien ren for he volailiy of he marke inex ocumene by Schwer 989. Our resuls on he effec of he capial gains ax cu on he volailiy of marke excess reurn an he volailiy of inusry porfolio reurns provie empirical suppor for he preicion ha sock reurn volailiy increases afer he capial gains ax rae is reuce. Our finings are consisen wih he explanaion ha a capial gains ax cu reuces he risk-sharing funcion of financial markes an increases sock reurn volailiy. C. Tax effec on he reurn volailiy of iniviual firms We firs examine he across boar effec on iniviual sock reurn volailiy of he capial gains ax cu uner he TRA 97. This is achieve by fiing equaion 4 using firm level aa. The resuls are repore in he las column of Table. Consisen wih he finings on he marke inex an inusry porfolios, he capial gains ax cu uner he TRA 97 increases he reurn volailiy of iniviual socks. The esimae coefficien

24 suggess ha he iniviual sock reurn volailiy is higher by 0.47 percen on average pos he capial gains ax cu han prior o he capial gains ax cu. The effec is highly saisically significan. The leverage effec is sronger a firm level han a inusry porfolio level. This is evience by highly saisically significan negaive coefficien esimaes for boh r i an r i. Sock reurn volailiy is also more persisen han boh he marke inex an inusry porfolios as inicae by highly saisically significan posiive coefficien esimaes for boh σ i an σ i. Furher, mos of he macroeconomic variables have saisically significan effec on he reurn volailiy a firm level. These inclue he consumpion-wealh raio, he sochasically erene risk free rae, he growh rae of inusrial proucion, an lagge marke reurns. However, ifferen firms have ifferen ax liabiliies boh curren an possible fuure liabiliies an offer ifferen risk-sharing opporuniies. When he capial gains ax rae changes, invesors respon ifferenly epening upon firms characerisics. This leas o ifferen ax effecs on he reurn volailiy of iniviual socks. As our analysis above shows, while all socks will experience increases in heir reurn volailiy ue o he reuce risk-sharing associae wih he capial gains ax cu, he increase in volailiy will be smaller if he firm pays iviens an higher if he firm has large embee capial gains or losses. To joinly es he across boar effec an he cross-secional effec of a capial gains ax change on iniviual sock reurn volailiy, we perform regression analysis using equaions 5 an 6. Since he exene specificaion offers a richer seup, our iscussions on he join es of he across boar effec an he crosssecional effec of he capial gains ax cu will be focuse on he resuls of equaion 6. Table 3 repors he resuls of he regression analysis on join es of he across boar effec an he cross-secional effec of he capial gains ax cu uner he TRA 97 for he baseline 8 monh embee capial gains or losses using he basic join specificaion equaion 5. The ax-sensiive invesor ownership is measure eiher by he percenage of shares owne by iniviual invesors he group irecly affece by he TRA 97 or he percenage of shares owne by iniviual invesors an muual funs. Consisen wih he preicions of our analysis, he coefficien for he ummy variable Pos is posiive an saisically significan a percen level when he ax sensiive ownership is measure by eiher he percenage of shares owne by iniviual invesors 3

25 IND or he percenage of shares owne by iniviual invesors an muual funs combine IND&MF. The coefficien esimae suggess ha everyhing else he same he monhly reurn volailiy of iniviual socks is.05 percen higher, on average, afer enacmen of TRA97 for he IND group an.7 percen higher for he IND&MF group. The esimae coefficien for he ineracion Pos Yiel TSO is negaive inicaing socks wih higher ivien yiel an large ax-sensiive ownership experience lower reurn volailiy increase. This is consisen wih our preicion iscusse above. Bu he coefficien esimae is only marginally significan a 0 percen level when he TSO is measure by iniviual invesor ownership IND an is insignifican for IND&MF. Consisen wih he preicion of our analysis, socks wih large embee losses an gains experience an high ax-sensiive ownership experience higher reurn volailiy increase. Specifically, he esimae coefficien for negaive inicaing socks wih larger losses experiencing higher reurn volailiy increase afer he capial gains ax cu uner he TRA 97. In he meanime, he esimae coefficien for Pos Gains TSO is posiive suggesing socks wih larger embee gains experiencing higher reurn volailiy increase afer he capial gains ax cu. The finings are highly saisically significan for boh measures of ax-sensiive ownership. Furher, he coefficien esimae for he ineracion Pos Losses TSO Pos TSO is negaive an highly saisically significan. This inicaes ha firms wih high ax sensiive invesor ownership experience a smaller reurn volailiy increases afer he ax rae cu an is consisen wih he risk sharing role of he capial gains ax. Table 4 repors he resuls of he regression analysis on iniviual sock reurn volailiy for he baseline case using he exene join specificaion equaion 6. Consisen wih he finings repore for he basic join specificaion equaion 5, he coefficien for he ummy variable Pos is posiive an saisically significan a percen level when he ax sensiive ownership is measure by eiher he percenage of shares owne by iniviual invesors IND or he percenage of shares owne by iniviual invesors an muual funs combine IND&MF. The coefficien esimaes also are very similar o esimae coefficiens repore in Table 3. The ineracion Pos Yiel TSO DL is negaive inicaing ha higher ivien-paying socks wih large ax sensiive invesor ownership will experience is 4

26 smaller increases in reurn volailiy han lower ivien-paying socks afer he capial gains ax cu. The esimae coefficien is 5. 8 an significan a convenional 5 percen level wih a p-value of when he TSO is measure by he IND. When he TSO is measure by he percenage of shares owne by iniviual invesors an muual funs combine IND&MF, he esimae is 3. 9 an saisically significan a 0 percen level wih a p-value of The coefficien esimae for he ineracion Pos Yiel TSO DG is also negaive bu no saisically significan for eiher measure of ax sensiive invesor ownership. The resul suggess ha he effec of lower volailiy increase for ivien-paying socks is concenrae primarily on ivienpaying socks experience price ecline in he pas 8 monhs. The ineracion erm Pos Losses TSO has a negaive coefficien inicaing ha socks wih larger embee capial losses Losses<0 an high ax sensiive ownership experience higher volailiy increase afer he capial gains ax cu. The coefficien esimae is highly saisically significan for boh measures of ax sensiive invesor ownership IND an IND&MF wih a p-value less han percen. The esimae coefficien implies ha for socks wih average percenage of iniviual invesor ownership IND, for every 50 percen higher losses, he monhly reurn volailiy increase is higher by.4 percen % 6.06% afer he capial gains ax cu han before he capial gains ax cu. When he ax sensiive ownership is measure by he IND&MF, he esimae coefficien suggess ha for a 50 percen higher loss, he monhly reurn volailiy increase of iniviual socks is higher by.84 percen % 73.77% afer he capial gains ax cu. In boh cases, our esimaes sugges ha he reurn volailiy of socks wih large embee capial losses an high ax sensiive ownership experiences large increase afer he capial gains ax cu because of reuce risk sharing wih he governmen on socks wih loss posiions. For socks wih embee capial gains, we furher ecompose hem ino nonivien paying versus ivien paying socks. The coefficiens for boh ineracion erms Pos Gains TSO NDiv an Pos Gains TSO Div are posiive implying socks wih large embee capial gains will see higher reurn volailiy increase afer he capial gains ax cu. The ineracion Pos Gains TSO NDiv is highly significan wih a p-value less han percen when he ax sensiive invesor ownership is measure 5

27 by boh he IND an he IND&MF. The esimae coefficien suggess ha for nonivien paying socks wih average percenage of iniviual invesor ownership, for every 50 percen higher embee gains, he average monhly reurn volailiy will be higher by 0.44 percen.43 50% 6.06% afer he capial gains ax cu han before he capial gains ax cu. When he ax sensiive invesor ownership is measure by IND&MF, he esimae coefficien suggess ha for a 50 percen higher embee gain he average monhly reurn volailiy is higher by 0.69 percen.87 50% 73.77% afer he capial gains ax cu. Similarly, he ineracion Pos Gains TSO Div is also highly significan wih a p-value less han percen when he ax sensiive invesor ownership is measure by boh he IND an he IND&MF. The increases in reurn volailiy for ivien-paying firms are however slighly smaller han for he non-ivien paying firms. The coefficien for NDiv is posiive an highly saisically significan for boh regressions, inicaing ha non-ivien paying socks have higher reurn volailiy hroughou he sample perio. Socks wih large embee gains an losses also experience higher volailiy as inicae by a significan posiive coefficien for he gains variable Gains an a significan negaive coefficien for he loss variable Losses. The coefficien esimae for he ineracion Pos TSO is negaive an highly saisically significan as repore in Table 3. Sock urnover also has a srong posiive effec on reurn volailiy. This suggess ha higher urnover is associae wih higher reurn volailiy. The coefficien for BiAskSprea is posiive an highly saisically significan. One possible explanaion is ha a wier bi-ask sprea allows for larger price movemen an leas o higher reurn volailiy. Finally, firm size has a highly significan an nonlinear effec on he reurn volailiy of iniviual socks. Some of he conrol variables also have significan effec on he monhly iniviual sock reurn volailiy. Specifically, he consumpion-wealh raio CAY has a posiive effec on sock reurn volailiy. The growh rae of he inusrial proucion has a negaive coefficien implying ha sock reurn volailiy is likely o be higher when he overall economy performs poorly. We also see he asymmery in sock reurn volailiy as shown by he negaive coefficiens for boh r i an r i. Iniviual sock reurn 6

28 volailiy exhibis some persisence inicae by a posiive an significan coefficien for σ i. Overall, our cross-secional regression analysis provies supporing evience for our preicion on he effec of a capial gains ax cu on he reurn volailiy of iniviual socks wih ifferen characerisics. The finings inicae ha in he case of a capial gains ax cu he reuce risk sharing beween invesors an he governmen ens o increase he reurn volailiy of iniviual socks in general. In paricular, higher ivien-paying socks wih ecline sock price experience smaller reurn volailiy increases. Socks wih large embee capial gains an losses experience higher reurn volailiy increases han oher socks because of larger reucion in risk sharing beween invesors an he governmen in he case of a capial gains ax cu. D. Robusness check We now perform robusness check on our finings repore above using he exene join specificaion equaion 6. Firs, we use alernaive measures of embee capial gains an losses calculae using ifferen holing perios. Three alernaive measures of he embee capial gains an losses are examine. The firs is calculae base on he sock price change in he pas monhs one year, he secon is base on he sock price change in he pas 4 monhs wo years, an he hir is base on he sock price change in he pas 36 monhs hree years. Secon, we inrouce iniviual firm s growh opion measure by he forecase operaing income growh rae for hese firms. Thir, we exclue observaions in year 000 an 00 an use he subsample from January 994 o December 999 o perform our regression analysis. The analysis on he subsample allows us o aress wheher he increase volailiy is cause by he possibly higher volailiy cause by he afermah of he inerne bubble burs. Table 5 repors he resuls of he regression analysis on equaion 6 using he alernaive embee capial gains an losses measures base on he pas, 4, an 36 monh sock price change, respecively. In all hree cases, he ax sensiive ownership is measure by he percenage of shares owne by iniviual invesors he group irecly affece by TRA97. The coefficien esimaes are qualiaively similar o he baseline case. Specifically, he coefficien for he ummy variable Pos is posiive an highly saisically significan in all hree cases wih a p-value of The coefficien 7

29 esimae implies ha everyhing else he same he monhly iniviual sock reurn volailiy is higher by 0.9 percen for he monh sock price change, by.0 percen for he 4 monh sock price change, an by.6 percen for he 36 monh sock price change, respecively. The coefficien esimae for he ineracion Pos Yiel TSO DL remains negaive for all hree cases an is saisically significan a convenional 5 percen level for 4 an 36 monh sock price changes. The ineracion Pos Yiel TSO DG also has a negaive coefficien an is significan a 0 percen for 4 monh sock price change an a 5 percen for 36 monh sock price change. The esimae coefficien for he ineracion Pos Losses TSO is negaive a -.75 an saisically significan a 5 percen level for he monh sock price change, a -.8 wih a p-value of 0.00 for he 4 monh sock price change, an a -.6 wih a p-value of 0.0 for he 36 monh sock price change. All hree esimaes are consisen wih he coefficien esimae for he baseline 8 monh sock price change. The resuls offer aiional empirical suppor for he preicion ha socks wih large embee capial losses experience larger increase in reurn volailiy afer he capial gains ax cu. For ineracion erms Pos Gains TSO NDiv an Pos Gains TSO Div, our resuls using he alernaive measures of sock price change are also consisen wih he finings in he baseline case. In all hree cases, he coefficien esimaes for boh Pos Gains TSO NDiv an Pos Gains TSO Div remain posiive as in he baseline case. Furher, he ineracion Pos Gains TSO Div is saisically significan a 5 percen for all hree holing perios. The ineracion Pos Gains TSO NDiv is highly significan a monh holing perio an also significan 0 percen level for 4 an 36 monh holing perio. The coefficien esimaes for NDiv, Gains, Losses, an he ineracion Pos TSO all have he same sign an similar magniue as heir counerpar in he baseline case an remain highly saisically significan. Finally, he aggregae conrol variables also have similar effec on he sock reurn volailiy as in he baseline case. Xu an Malkiel 003 an Cao, Simins, an Zhao 006 ocumen ha firm s growh poenials have a significan impac on a firm s iiosyncraic volailiy. In Table 6, we inclue he forecase operaing income growh rae as a conrol variable o proximae for a firm s growh poenial. Because only a subse of firms have forecase 8

30 operaing income growh rae, he number of observaions use in our regression analysis is much smaller han ha in he baseline case. However, he esimae coefficien for he ummy variable Pos remains highly saisically significan wih a p-value less han percen. The coefficien esimaes for Pos Yiel TSO DL remain negaive bu insignifican a convenional es level. The ineracion Pos Losses TSO has a negaive coefficien as in he baseline case. The esimae coefficiens are -4.9 an -5.6 for he wo measures of ax sensiive ownership IND an IND&MF, respecively, an are slighly larger in magniue han in he baseline case. The esimae coefficiens for he ineracions Pos Gains TSO NDiv an Pos Gains TSO Div are very close o heir counerpars in he baseline case. The esimaes are also saisically significan a percen level. Furher, he coefficien esimaes for NDiv, Gains, Losses, an he ineracion Pos TSO all have he same sign an similar magniue as heir counerpar in he baseline case. Consisen wih he fining in Xu an Malkiel 003, he forecase operaing income growh rae GrowhOpion has a posiive effec on he monhly iniviual sock reurn volailiy. The effec is highly saisically significan wih a p- value of This inicaes ha firms wih higher forecase operaing income growh rae will also have more uncerainy an hus higher risk. The esimae coefficien for GrowhOpion is very similar a 0.09 an 0.09 for he wo measures of ax sensiive ownership IND an IND&MF, respecively. In Table 7, we repor he regression analysis resuls for he subsample from January 994 o December 999. The sign an saisical significance of he coefficien esimaes for key ax-relae variables using he subsample remain similar o he baseline case. The esimae coefficien for he ummy variable Pos is posiive an highly saisically significan as in he baseline case. The magniue of he coefficien esimae is higher han in he baseline case. For his subperio, he monhly reurn volailiy is abou.96 o.6 percen higher afer he capial gains ax cu han before he capial gains ax cu when he ax sensiive ownership is measure by he percenage of shares owne by iniviual invesors IND an he percenage of shares owne by iniviual invesors an muual funs combine IND&MF, respecively. The coefficien esimaes for boh Pos Yiel TSO DG an Pos Yiel TSO DL are negaive an consisen wih our preicion. As in he baseline case, he coefficien esimae is only 9

31 significan for Pos Yiel TSO DL. The p-value is less han percen for boh measures of ax sensiive ownership IND an IND&MF. The magniue of he coefficien esimaes is much higher han in he baseline case. The coefficien esimae for he ineracion Pos Losses TSO is negaive as in he baseline case an is saisically significan a percen level. The esimae ranges from -.79 o for boh measures of he ax sensiive ownership an smaller in magniue han he esimae for he baseline case. Finally, he coefficien esimaes for ineracions Pos Gains TSO NDiv an Pos Gains TSO Div are also similar o he baseline case. The effecs are highly saisically significan wih p-values consisenly lower han for boh measures of ax sensiive ownership. Once again, he coefficien esimaes for NDiv, Gains, Losses, an he ineracion Pos TSO have he same sign an similar magniue as heir counerpar in he baseline case an remain highly saisically significan. Overall, our robusness analysis resuls sugges ha our finings on he crosssecional effec on sock reurn volailiy associae wih a capial gains ax cu are robus an broaly consisen wih our preicions iscusse in Secion. 5. Conclusion We analyze he effec of capial gains axes on he volailiy of sock reurns. Our analysis preics ha reucing capial gains axes increases he sock reurn volailiy because a capial gains ax cu reuces he risk sharing role of financial markes beween invesors an he governmen. The effec of a capial gains ax change on sock reurn volailiy varies epening upon ivien isribuion an he size of he embee capial gains an losses. Using he Tax Relief Ac of 997, we empirically es he preicions on he sock reurn volailiy of a capial gains ax cu. Our empirical analysis provies srong suppor for he preicions of our analysis for boh he reurn volailiy of he marke inex an inusry porfolios an he cross-secional implicaions for iniviual sock reurn volailiy. Higher ivien-paying socks wih ecline sock price experience a smaller increase in reurn volailiy an socks wih large embee capial gains an losses show a larger increase in reurn volailiy afer a capial gains ax rae reucion. 30

32 While a capial gains ax cu increases sock reurn volailiy, invesors are no necessarily worse off. From invesors perspecive, he expece invesmen opporuniies or he risk an reurn rae-off are he key consieraion for long-erm invesmen ecisions. A capial gains ax cu may also increase invesors afer-ax sock reurn leaing o beer risk an reurn rae-off. In his case, invesors may benefi from a capial gains ax cu. I is ineresing o see he effec of a capial gains ax cu on he risk an reurn rae-off on sock invesmen. We leave his for fuure research. 3

33 Appenix: A Moel on Capial Gains Taxes an Sock Reurn Volailiy The economy is populae wih a large number of ax sensiive represenaive invesors. Each invesor erives uiliy from consuming a numeraire goo. Besies consumpion, he invesor also invess his savings in a one-perio riskless bon an N risky socks. Holing one uni of he riskless bon pays off one uni of consumpion in nex perio. The payoff o holing one share of a risky sock consiss of ivien an capial gains. We assume ha earne ineress are axe a he effecive income ax raeτ i, ivien is axe a he effecive rae ofτ, an he capial gains are axe a he effecive ax rae of τ c. Consiering he possible exempions, ax creis, an complex neing rules allowe by he ax coe, we allow he effecive ax raes o be ifferen from s s s he sauory rae enoe as,, an, respecively. However, we assume ha he τ i τ τ c effecive ax raes are increasing funcions of heir respecive sauory raes, i.e., τ τ i s i > 0, τ τ s > 0, τ c an > 0. s τ c Le C be he invesor s ime consumpion expeniure, B be he invesor s ime f bon invesmen, be he invesor s ime holing of sock i, be he risk free rae a X i ime, P be he ime price of sock i, an be he ivien isribuion of sock i. We i assume ha he invesor s objecive is o maximize he expece iscoune life ime uiliy subjec o he ineremporal buge consrain, i.e., i r s.. MaxE C B 0 = 0 β u C N N f Pi X i = [ τ i r ] B [ Pi τ i ] X i i= i= τ G c i A where β is he invesor s subjecive iscoun facor an he las erm in he buge consrain represens he invesor s capial gains axes a ime. We assume ha he invesor s capial gains axes are given by he following specificaion N i= N τ G = τ [ P P A c i i= c i i ] X i. 3

34 While he ax liabiliy is calculae using he previous perio price as he basis, he specificaion allows he invesor o use efficien raing sraegies o lower his ax liabiliy. This is reflece in he effecive capial gains ax rae being lower han he sauory rae. The firs-orer coniion of maximizing he invesor s objecive funcion yiels he pricing equaion for risky sock i as follows P [ τ P τ P τ ]. u' C β c i c i i A3 u' C i = E We furher assume ha he invesor s preference is represene by he logarihmic uiliy funcion, i.e., u C = ln C. Le = i be he aggregae iviens a ime. Using he marke clearing coniion on he consumpion goos, we have P N i= [ τ P τ P τ ]. β A4 i = E c i c i i Rearranging he above equaion yiels P [ τ P τ ]. / β c i i A5 βτ ce / i = E For analyical racabiliy, we assume ha E / = < for all. The soluion o he above equaion is hen given by δ P i = j i j τ β E, A6 j τ c = j β τ c where β = <. βδτ c To erive esable empirical implicaions, we se he number of risky socks o wo N =. Specifically, we le sock be he low ivien paying sock an sock be he high ivien paying sock. Le ε be a ranom variable isribue in [0,] an follow a markov process for which E ε k = ρ ε, <. k ρ We can specify he ivien isribuion of he wo firms as follows = ε, = ε. A7 33

35 For he above specificaion, i is sraighforwar o show ha., j j j j j j E E ε ρ ε ρ = = A8 Using he above resuls, we arrive a he following expressions for he prices of he wo socks., c c P P = = ε β β τ τ ε β β τ τ A9 The expressions in A9 suggess ha he high ivien paying sock wo has a higher price han he low ivien paying sock one, i.e., is greaer han Denoe he ex-ivien sock reurn as he percenage price appreciaion from perio o perio. We have P. P., = = c c P r P r ε β β τ τ ε β β τ τ A0 Denoe he coniional variance of sock reurns as If we assume ha he spli of iviens beween wo socks is inepenen from he aggregae ivien, we arrive a he following expression for he coniional variance of sock an :. i r Var. = c P Var Var Var E Var r Var τ τ ε ε ρε β β A. = c P Var Var Var E Var r Var τ τ ε ε ρε β β A 34

36 Subsiuing in an rearranging, we have β, = c c c c P Var Var Var E Var r Var τ ε τ δ ρ β ε τ δ ρ β ρε τ δ ρ β τ δ β β β A3. = c c c c P Var Var Var E Var r Var τ ε τ δ ρ β ε τ δ ρ β ρε τ δ ρ β τ δ β β β A4 Since < ρ an ], [0, ε he coniional variance of boh sock reurns increase ecrease as he capial gains ax rae ecreases increases uner he coniion. δ ρ > Because a firm s ivien process is ofen very persisen, his coniion will be saisfie in mos siuaions. Since he marke porfolio is a value weighe average of iniviual socks, our resul also suggess ha he volailiy of he reurns o he marke porfolio will increase ecrease when he capial gains ax rae is reuce increase uner he same coniion. In aiion, equaions A3 an A4 also have cross-secional implicaions. Because he low ivien paying sock has a lower price, i will more likely have a larger reurn volailiy response o he change in he capial gains ax rae han he high ivien paying sock. In he case of a capial gains ax rae cu, he reurn volailiy of a low ivien paying sock will increase more han ha of a high ivien paying sock. 35

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38 Harrison, J. Michael, an Davi M. Kreps, 979, Maringales an arbirage in muliperio securiies markes, Journal of Economic Theory, 0, Lang, M., an D. Shackelfor, 000, Capializaion of capial gains axes: Evience from sock price reacions o he 997 rae reucion, Journal of Public Economics 76, Jin, Li 005, Capial gain ax overhang an price pressure, Journal of Finance 6, Mankiw, N., an S. Zeles, 99, The consumpion of sockholers an nonsockholers, Journal of Financial Economics 9, 97-. Pasor, L., an P. Veronesi, 006, Was here a Nasaq bubble in 990s? Journal of Financial Economics 8, Peerson, M., 005, Esimaing sanar error in finance panel aa ses: Comparing approaches, working paper, Kellogg School of Managemen, Norhwesern Universiy. Reese, W., 998, Capial gains axaion an sock marke aciviy: Evience from IPOs, Journal of Finance 53, Schwer, G.W., 987, Why oes sock marke volailiy change over ime? Journal of Finance 44, Sinai, T. an J. Gyourko, 004, The asse price incience of capial gains axes: Evience from he Taxpayer Relief Ac of 997 an publicly-rae real esae firms, Journal of Public Economics 88, Xu, Y., an B. Malkiel, 003, Invesigaing he Behavior of Iiosyncraic Volailiy, Journal of Business 76,

39 Table Summary Saisics Variable Mean Meian S Min Max Panel A: marke or inusry level variables r σ r r r r r σ σ σ σ σ CAY RREL GIP Panel B: iniviual firm level variables r i σ i Yiel Div P / P IND IND&MF D/A Size Turnover BiAskSprea GrowhOpion r is he average aily excess reurn of value-weighe CRSP sock inex a monh ; σ is he monhly volailiy of he excess reurn of he value-weighe CRSP sock inex a monh ;, k =,...,5, is he average aily reurn for monh for he five inusry porfolios efine by Fama an French; is he monhly volailiy of he five inusry porfolios a monh ; CAY is he emeane σ, k =,...,5, k consumpion-wealh raio; RREL is he sochasically erene risk free rae; GIP is he growh rae of inusrial proucion; r i is he average aily reurn of iniviual socks a monh ; σ i is he monhly reurn volailiy of iniviual socks a monh ; Div is a ummy variable which akes value of if a firm r k 38

40 isribue ivien in prior year an 0 oherwise; Yiel is ivien isribue in prior year ivie by share price in mos recen monh prior o ; P / P is 8-monh sock price change up o he mos recen monh prior o ; IND is he percenage of shares of socks owne by iniviual invesors; IND&MF is he percenage of shares of socks owne by iniviual invesors an muual funs combine; D/A is firms eb-asse raio in he mos recen quarer; Size is he logarihmic marke value of a firm; Turnover is monhly raing volume ivie by ousaning shares in prior monh; BiAskSprea is he average monhly percenage bi-ask sprea for iniviual socks from prior monh, an GrowhOpion is he analys forecas for firm s long-erm operaing income growh rae. 39

41 Table Marke an Inusry Regression Analysis This able repors he regression resuls on he effec of TRA97 on he monhly volailiy of he excess reurn of he value-weighe CRSP sock inex equaion 3, he reurn volailiy of five inusry porfolios equaion 4 incluing consumer In., manufacuring In., high ech In. 3, healhcare In. 4, an ohers In. 5 consruce using 4 igi SIC coe, an on he across boar effec of TRA97 on monhly volailiy of iniviual sock reurns fie o equaion 4. The numbers in parenheses are p-values. See able for variable efiniions. Pos is a ummy variable which akes value of if he observaion is afer 6//997 an 0 if i is before 3/3/997. The las column is for iniviual firms. Variable Pre. Marke In. In. In. 3 In. 4 In. 5 Iniviual sign consumer manufac. high ech. healhcare ohers Firms Pos σ σ CAY CAY RREL RREL GIP GIP r r r i i r σ i σ i N ,745 Aj. R N/A 40

42 Table 3 Iniviual Sock Regression Analysis Basic Join Specificaion This able repors he regression resuls on he effec of TRA97 on he monhly reurn volailiy of iniviual socks for he basic join specificaion equaion 5. The embee capial losses Losses an gains Gains are calculae base on pas 8-monh sock price change up o he mos recen monh. Two measures of ax-sensiive ownership TSO are use: iniviual ownership an iniviual an muual fun ownership. The equaion is esimae using clusere sanar error esimaion meho o accoun for possible correlae resiuals in our panel aa. The gooness of fi measure is represene by - resiual loglikelihoo. Sample perio covers January of 994 o December of 00. See Table for variable efiniions. Pos is a ummy variable which akes value of if he observaion is afer 6//997 an 0 if i is before 3/3/997. Iniviual ownership Iniviual an muual fun Ownership Variable Preicion Esimae P-value Esimae P-value Pos Pos*Yiel*TSO Pos*Losses*TSO Pos*Gains*TSO NDiv Yiel Gains Losses Yiel*Gains Yiel*Losses NDiv*TSO NDiv*Gains NDiv*Losses Pos*Yiel Pos*Gains Pos*Losses Pos*Yiel*Gains Pos*Yiel*Losses Pos*TSO Size Size Size Size D/A InsOwn Turnover

43 BiAskSprea σ σ CAY CAY GIP GIP RREL RREL r r σ i σ i r i r i N 43,737 43,737 - res. Loglikelihoo 99,387 99,384 4

44 Table 4 Iniviual Sock Regression Analysis Exene Join Specificaion This able repors he regression resuls on he effec of TRA97 on he monhly reurn volailiy of iniviual socks for he exene join specificaion equaion 6. The embee capial losses Losses an gains Gains are calculae base on pas 8-monh sock price change up o he mos recen monh. Two measures of ax sensiive ownership TSO are use: iniviual ownership an iniviual an muual fun ownership. The equaion is esimae using clusere sanar error esimaion meho o accoun for possible correlae resiuals in our panel aa. The gooness of fi measure is represene by - resiual log-likelihoo. Sample perio covers January of 994 o December of 00. See Table for variable efiniions. Pos is a ummy variable which akes value of if he observaion is afer 6//997 an 0 if i is before 3/3/997. Iniviual ownership Iniviual an muual fun Ownership Variable Preicion Esimae P-value Esimae P-value Pos Pos*Yiel*TSO*DL Pos*Yiel*TSO*DG Pos*Losses*TSO Pos*Gains*TSO*NDiv Pos*Gains*TSO*Div NDiv Yiel Gains Losses Yiel*Gains Yiel*Losses NDiv*TSO NDiv*Gains NDiv*Losses Pos*Yiel Pos*Gains Pos*Losses Pos*Yiel*Gains Pos*Yiel*Losses Pos*TSO Size Size Size Size D/A

45 InsOwn Turnover BiAskSprea σ σ CAY CAY GIP GIP RREL RREL r r σ i σ i r i r i N 43,737 43,737 - res. Loglikelihoo 99,376 99,375 44

46 Table 5 Iniviual Sock Regression Analysis for Differen Holing Perio This able repors he robusness check resuls on he effec of he TRA97 on he reurn volailiy of iniviual socks for he exene join specificaion equaion 6 for hree alernaive measures of embee capial losses Losses an gains Gains using pas -monh, 4-monh or 36-monh price change up o he mos recen monh. The ax sensiive ownership is measure by he percenage of shares owne by iniviual invesors. The equaion is esimae using clusere sanar error esimaion meho o accoun for possible correlae resiuals in our panel aa. The gooness of fi measure is represene by - resiual log-likelihoo. See Table for variable efiniions. Pos is a ummy variable which akes value of if he observaion is afer 6//997 an 0 if i is before 3/3/997. monhs 4 monhs 36 monhs Variable Preicion Parameer P-value Parameer P-value Parameer P-value Pos Pos*Yiel*TSO*DL Pos*Yiel*TSO*DG Pos*Losses*TSO Pos*Gains*TSO*NDiv Pos*Gains*TSO*Div NDiv Yiel Gains Losses Yiel*Gains Yiel*Losses NDiv*TSO NDiv*Gains NDiv*Losses Pos*Yiel Pos*Gains Pos*Losses Pos*Yiel*Gains Pos*Yiel*Losses Pos*TSO Size Size Size Size D/A

47 InsOwm Turnover BiAskSprea σ σ CAY CAY GIP GIP RREL RREL r r σ i σ i r i r i N 5,64 37,89 8,85 - res. Loglikelihoo 98,75 890, ,7 46

48 Table 6 Iniviual Sock Regression Analysis wih Growh Opions This able repors he regression resuls on he effec of TRA97 on he monhly reurn volailiy of iniviual socks for he exene join specificaion equaion 6. The embee capial losses Losses an gains Gains are calculae base on pas 8-monh sock price change up o he mos recen monh. Two measures of ax sensiive ownership TSO are use: iniviual ownership an iniviual an muual fun ownership. The equaion is esimae using clusere sanar error esimaion meho o accoun for possible correlae resiuals in our panel aa. The gooness of fi measure is represene by - resiual loglikelihoo. Sample perio covers January of 994 o December of 00. See Table for variable efiniions. Pos is a ummy variable which akes value of if he observaion is afer 6//997 an 0 if i is before 3/3/997. Iniviual ownership Iniviual an muual fun Ownership Variable Preicion Esimae P-value Esimae P=value Pos Pos*Yiel*TSO*DL Pos*Yiel*TSO*DG Pos*Losses*TSO Pos*Gains*TSO*NDiv Pos*Gains*TSO*Div NDiv Yiel Gains Losses Yiel*Gains Yiel*Losses NDiv*TSO NDiv*Gains NDiv*Losses Pos*Yiel Pos*Gains Pos*Losses Pos*Yiel*Gains Pos*Yiel*Losses Pos*TSO Size Size Size Size D/A

49 InsOwn Turnover BiAskSprea GrowhOpion σ σ CAY CAY GIP GIP RREL RREL r r σ i σ i r i r i N 88,774 88,774 - res. Loglikelihoo 56,385 56,393 48

50 Table 7 Iniviual Sock Regression Analysis for Subsample This able repors he regression resuls on he effec of TRA97 on he monhly reurn volailiy of iniviual socks for exene join specificaion equaion 6. The embee capial losses Losses an gains Gains are calculae base on pas 8-monh sock price change up o he mos recen monh. Two measures of ax sensiive ownership TSO are use: iniviual ownership an iniviual an muual fun ownership. The equaion is esimae using clusere sanar error esimaion meho o accoun for possible correlae resiuals in our panel aa. The gooness of fi measure is represene by - resiual loglikelihoo. Sample perio covers January of 994 o December of 999. See Table for variable efiniions. Pos is a ummy variable which akes value of if he observaion is afer 6//997 an 0 if i is before 3/3/997. Iniviual ownership Iniviual an muual fun Ownership Variable Preicion Esimae P-value Esimae P=value Pos Pos*Yiel*TSO*DL Pos*Yiel*TSO*DG Pos*Losses*TSO Pos*Gains*TSO*NDiv Pos*Gains*TSO*Div NDiv Yiel Gains Losses Yiel*Gains Yiel*Losses NDiv*TSO NDiv*Gains NDiv*Losses Pos*Yiel Pos*Gains Pos*Losses Pos*Yiel*Gains Pos*Yiel*Losses Pos*TSO Size Size Size Size D/A

51 InsOwn Turnover BiAskSprea σ σ CAY CAY GIP GIP RREL RREL r r σ i σ i r i r i N 0,68 0,68 - res. Loglikelihoo 638, ,489 50