The capital gains tax “lock-in” effect and equity offerings

The essays presented here are focused on the impact of capital gains tax “lock-in” effect on equity prices and returns before and after the equity offerings. In the first essay, I theoretically document how investor’s deferral or “lock-in” term, as developed by Klein (1998), reacts to a Seasoned Equity Offering (SEO) that increases the existing number of shares in the market. I argue with the model and some numerical examples that prices and returns around SEO, reflect tax “lock-in” effect, and this “lock-in” term decreases from pre-SEO to post-SEO. This reduction in “lock-in” should decrease the post-SEO price from pre-SEO price that helps explain the negative SEO offer day return puzzle ceteris paribus. The second essay empirically tests the effect of capital gains tax “lock-in” on the abnormal issuance day return around SEOs using an event study setting. I find that the abnormal negative offer day return on the SEO issue day is more negative for stocks with higher accrued gains prior to SEO. This larger drop in offer day closing price from pre-SEO price stems from the weakening of the reluctance to sell by the “locked-in” investors with more shares in the market due to SEO. This reduces investor’s post-SEO “deferral” or “lock-in” term. Using U.S. SEOs between 1990 to 2012, I find that SEO shares with high-accrued gains (more “locked-in”) before issuance experience more decline in prices after issuance. The third essay uses the Initial Public Offerings (IPOs) of U.S. common stocks as a platform to explain the capital gains tax “lock-in” effect. I contend that the “lock-in” effect around IPOs is induced by the U.S. tax codes that allow a preferential tax treatment for long-term (LT) holdings where long-term capital (LT) gains are taxed at a lower rate than short-term (ST) gains. Applying Klein’s (1998) “lock-in” model on IPOs and using a large sample of IPOs from 1987 to 2015, I show that for initial investors who just subscribed to the IPOs, their “lock-in” is explained by the differential ST and LT tax rates along with accrued first day gains ceteris paribus.