Alex Kontoghiorghes

Do lower taxes lead to higher stock prices? Do companies consider tax rates when deciding on their dividend pay-outs and whether to issue new capital? If you’re thinking ‘yes’, you might be surprised to know that there was little real-world evidence (let alone UK-based evidence) which finds a strong link between personal investment tax rates on the one hand, and stock prices and the financial decisions of companies on the other. In this post, I summarise the findings from a recent study which shows that capital gains and dividend taxes do indeed have big effects on risk-adjusted equity returns, as well as the dividend, capital structure, and real investment decisions of companies.

Background

What drives stock returns? This is one of the oldest and most important questions in financial economics. While a lot of attention has been paid to the analysis of predictors such as company valuation ratios, market betas, momentum effects, and so on, in this blog post I advocate that taxes are an important and often overlooked predictor of stock returns.

I advocate this due to the findings of a unique natural experiment in the UK, which involved a lesser-known segment of fast-growing UK publicly listed companies, and which provided an ideal setting to study the effects of a very large tax cut. In summary, once Alternative Investment Market (AIM) companies were permitted to be held in tax-efficient Individual Savings Accounts (ISAs) for the first time in 2013, their prices became permanently higher than they would have been, their risk adjusted excess stock returns fell commensurately with the fall in their effective tax rates, dividend payments increased by a quarter, companies issued more equity and debt in response to their new lower cost of capital, and finally, companies used their newly issued capital to invest in their tangible assets and increase pay to their employees. Want to find out more? Keep reading.

Background and methodology

Around 10 years ago (July 2013 to be exact) the then Chancellor of the Exchequer George Osborne announced that stocks listed on the Alternative Investment Market (AIM), a sub-market of the London Stock Exchange, could from August 2013 onwards be held in a capital gains and dividend tax-exempt individual savings account (ISA) for the first time. This was a very important change for AIM-listed companies, and they had been calling for this equalisation of tax treatment for many years as stocks and shares ISAs hold billions of pounds of retail investors’ savings.

Since main market London Stock Exchange Stocks (such as the FTSE All-Share companies) were always eligible to be held in ISAs, this provided a unique natural experiment to study what happens to various company outcomes when their owners’ effective personal tax rate suddenly becomes zero. To see how big this tax cut was, Figure 1 shows that pretty much overnight, the effective AIM tax rate for retail investors (the amount of return percentage points paid out in tax, calculated as the sum of the stock’s capital gain and dividend yield components) went from around 10% per year to 0% after AIM stocks could be held in ISAs, a huge decrease in the world of personal taxation.

Figure 1: Average effective tax rate of AIM stocks before and after legislation change

The equivalent effective tax rate for main market stocks when held in ISAs during this period was always 0%, which is why they are used as the control group in this study.

Using a difference-in-differences approach with a matched London Stock Exchange control group, I investigate the effect of the tax cut on the equity cost of capital and company financial decisions. The matched control group is created using the following important characteristics: firm size, age, sector, book-to-market ratio, and market beta, to ensure that the results are less likely to be driven by unobservable AIM company-specific factors.

What I find

Relative to the control group, I find that AIM stock prices initially jumped as retail investors and retail-focused institutions increased their relative ownership after the legislation change. I also find that long-run pre-tax stock returns decreased by 0.9 percentage points per month to reflect their lower required rate of return (investors no longer required compensation for their tax liability). This amount is statistically equivalent to the monthly effective tax rate AIM companies faced before the change in legislation (0.9% x 12 ≈ 10%).

On the company side, I find that dividend payments increased by around a quarter to reflect the lower tax liability faced by their investors. Furthermore, in response to their lower cost of capital, AIM companies issued both more equity and debt. Finally, in-line with the ‘traditional view’ of corporate investment theory, AIM companies substantially increased their tangible assets (for example factories, warehouses, and machinery), and increased total pay to their employees. Regarding the external validity of these results, it is important to mention that AIM companies are generally smaller and faster growing than the average UK publicly listed company, and their relatively more concentrated ownership structure will also be a factor in their pay-out and investment decisions.

Implications for policymakers

These findings have important policy implications on a number of levels. My study revealed that changing the level of investment taxes is an effective tool to incentivise capital flows into certain assets. When similar assets have differing rates of investment taxes, this can cause substantial distortions to company valuations, as reflected by the large change in the annual returns of AIM listed companies. A lower cost of capital means companies have higher stock prices and can raise capital on more favourable terms.

My findings showed that equalising investment taxes between AIM and main market London Stock Exchange companies enabled a more efficient flow of capital to small, growing, and often financially constrained UK companies, and potentially allowed a more efficient flow of dividend capital to shareholders which was previously impeded due to higher rates of taxation.

Finally, my findings show that a permanently lower cost of capital incentivised AIM companies to issue more equity and debt post tax-cut, and companies used this new capital to invest in their tangible capital stock, and increase the total pay to their employees, which was a stated intended consequence of the legislation change.

Alex Kontoghiorghes works in the Bank’s Monetary and Financial Conditions Division.

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In China and Latin America: Development, Agency and Geopolitics, Chris Alden and Álvaro Méndez examine Latin America and the Caribbean region’s interactions with China, revealing how a complex, evolving set of bilateral economic and political relations with Beijing – from Buenos Aires to Mexico City – have shaped recent development. Mark S. Langevin contends that the book is a noteworthy contribution to an understanding of China’s footprint in the region but does not offer a robust framework for comparative analysis.  

China and Latin America: Development, Agency and Geopolitics. Chris Alden and Álvaro Méndez. Bloomsbury. 2022.

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China and Latin America offers a thoroughly researched account of China’s economic and political impacts in Latin America and the Caribbean (LAC). Alden and Méndez pivot on China’s centuries-long presence in LAC to weave an analysis of trade, investment and migration patterns, detailing a thick description of economic and political relations with the region’s governments and stakeholders. Their historical examination and assessments of national government responses to China are appropriately framed by the unfolding geopolitical rivalry between Beijing and Washington. The book details China’s underlying logic and overwhelming importance to LAC, providing a valuable contribution to the growing literature assessing Beijing’s role in the region’s economic development and international relations.

China is not new to LAC; its longstanding ties with the region provide an economic and social foundation for the massive trade and investment flows in recent decades.

In the introduction, Alden and Méndez remind readers that China is not new to LAC; its longstanding ties with the region provide an economic and social foundation for the massive trade and investment flows in recent decades. In chapter one, the authors tell an intriguing story of China’s dependence on “New World silver,” European and LAC elite thirst for Chinese-produced silks and ceramics during the fall of the Ming Dynasty in the seventeenth century, and the enduring impacts of the flow of indentured Chinese workers to the region in the eighteenth century. Accordingly, Chinese working-class immigrants settled in “cities like Lima, Tijuana, Panama City and Havana…” providing a human bridge to China while suffering through waves of xenophobia and anti-Chinese repression. China and Latin America documents the economic and social linkages tempered through centuries-long trade, investment and migration – a neglected foundation for understanding LAC’s economic development in recent decades.

The book raises several leading questions. In the introduction, Alden and Méndez explore the “interests, strategies and practices of China,” questioning whether Beijing’s approach to LAC is similar to its role in Africa (14). They ask what motivates Beijing’s interests in the region and how LAC governments, firms and social actors have responded to China’s “deepening economic and political involvement in the region” (15).

Although the book is thick on economic and historical detail, its thematic analytical framework does not guide comparative explanation within LAC and across developing regions, including Africa.

Although the book is thick on economic and historical detail, its thematic analytical framework does not guide comparative explanation within LAC and across developing regions, including Africa. Alden and Méndez offer three “broad themes” for narrating their analysis: development, agency and geopolitics. These dimensions can guide examination of Beijing’s underlying logic and regional economic and political relations but are insufficient to explain the variable regional results that could stem from Chinese policies, trade and investment or even geopolitical endeavours. Consequently, Alden and Méndez emphasise “diplomacy and statecraft” and “sub-state and societal actors” as conceptual references but without the formal specification for selecting cases, testing explanations and comparing outcomes at the national and regional levels.

For example, the book explores several groups of Latin American nations and case studies of Brazil and Mexico. Chapter three’s treatment of Chile, Peru and Argentina, chapter four’s analysis of Venezuela, Ecuador and Bolivia, and chapter seven’s assessment of Central America and the Caribbean reflect similar patterns of development and diplomacy. However, these chapters do not present a systematic comparative analysis between these cases. Moreover, the authors’ slim selection method excludes Paraguay and Uruguay without assessing these nations’ participation in the Common Market of South America (Mercosur) along with Argentina and Brazil. Indeed, Uruguay’s recent proposal to ditch Mercosur and negotiate a bilateral trade treaty with Beijing makes it an interesting case for comparison with Mexico, given its longstanding ties to Canada and the US through the North American Free Trade Agreement (NAFTA) and its successor pact (USMCA).

In chapter four, Alden and Méndez explain how the “sustained rise in commodity prices” – much of it fuelled by Chinese demand – “enabled these governments to seek rents from export tax revenues and direct them toward development and social programmes,” an approach the authors associate with “neo-extractivism.” Accordingly, the so-called Bolivarian republics of Venezuela, Ecuador and Bolivia sought to replace their dependency on the U.S. with China. Beijing embraced the opportunity, but the growing Chinese footprint “obscured the commercial intent and practices pursued by Chinese firms” (103). In response, these nations’ governments grappled with increasing Chinese debt, among other externalities brought by Chinese firms, including the “willful neglect of the concerns of local communities, environmentalists and labour activists.” Indeed, as the authors point out, even Beijing grew weary of the region’s “high expectations” and the growing “costs of entanglements” (104).

The book’s treatment of Venezuela is pivotal because it details the most extreme case of commodity export dependence and debt-trap diplomacy in the region.

The book’s treatment of Venezuela is pivotal because it details the most extreme case of commodity export dependence and debt-trap diplomacy in the region. This sets an analytical benchmark that sharply contrasts with Brazil’s diversified commodity exports to China and the parallel influx of Chinese goods, foreign direct investment and migrants, along with the incipient pattern of technology transfer through the localisation of Chinese manufacturing firms in Brazil.

On the energy front, Venezuela shifted to government control over petroleum production after Hugo Chavez’s rise to power in the late 1990s, while Brazil partially liberalised the sector during the same period. The authors assess China’s rise and growing demand for petroleum products but do not explain the divergent policy approaches taken by Caracas and Brasilia. Did Venezuela’s deepening authoritarianism and Brazil’s vibrant democracy shape Beijing’s approach to these countries and help determine the different outcomes in the petroleum sector, or are the differences limited to these countries’ respective opportunities for crude oil production for export? Moreover, do these contrasting policy-response patterns explain diplomatic outcomes, including Caracas’ growing distance from Washington? Alden and Méndez contribute to our understanding but fall short of a comparable explanation of Venezuela and Brazil’s two very different paths.

Chapter eight offers a vital perspective of China’s presence in LAC within the emerging geopolitical landscape that pits Washington against Beijing.

In conclusion, chapter eight offers a vital perspective of China’s presence in LAC within the emerging geopolitical landscape that pits Washington against Beijing. The authors explain China’s deepening engagements, becoming an observer to the Organization of American States (OAS) in 2004 and the Inter-American Development Bank (IDB) in 2008, and President Xi Jinping’s trip to Brasilia in 2014 to attend the first Summit of Leaders of China and LAC. Xi’s confident embrace of the region did not initially spark concern in Washington, according to Alden and Méndez. However, as the authors recount, by 2018, the US National Defense Strategy Summary confirmed Washington’s acknowledgment of the strategic competition with Beijing throughout LAC.

Alden and Méndez raise a central question that should frame research and policymaking in the coming years: at what point do the citizens and leaders of LAC search for alternatives to ‘China’s dominant position in their country’s economic and political life?’

China and Latin America concludes, “No longer passive, Chinese diplomacy now looms large in the capitals and boardrooms across the region, leaving the once-unassailable US dominance scrambling to regain its standing” (175). Hence, Alden and Méndez raise a central question that should frame research and policymaking in the coming years: at what point do the citizens and leaders of LAC search for alternatives to “China’s dominant position in their country’s economic and political life?”

This post gives the views of the author, and not the position of the LSE Review of Books blog, or of the London School of Economics and Political Science. The LSE RB blog may receive a small commission if you choose to make a purchase through the above Amazon affiliate link. This is entirely independent of the coverage of the book on LSE Review of Books.

Image Credit: Nadezda Murmakova on Shutterstock.