Capital Gains Tax, Supply-Driven Trading and Ownership Structure: Direct Evidence of the Lock-In Effect

The lock-in effect suggests that capital gains tax (CGT) creates a disincentive to sell appreciated stocks, as CGT is imposed once stocks are sold. A CGT rate decrease reduces the reluctance to sell appreciated stocks, thereby increasing the supply available for sale. Our study tests the lock-in effect by examining supply-side trading for a sample of 410 Australian initial public offerings (IPOs) immediately following their 12-month anniversary of listing, the passing of which entitles their initial individual investors to a 50% discount on CGT payable. Doing so extends prior research in a number of ways. First, we combine buy-sell order imbalance and ownership structure data to provide direct evidence of the lock-in effect. Second, we analyze shifts in buy-sell order imbalance upon IPOs' qualification for discounted CGT treatment, as opposed to the effective date of CGT legislative reform, to minimize any compounding demand-side effects on order imbalance. Third, we examine whether selling pressure (upon qualification for discounted CGT treatment) is more pronounced at the beginning of the financial year, as individual investors delay the realization of capital gains until July to postpone their resultant CGT liability, whilst also controlling for the passing of escrow-expiration dates. Our results confirm an increase in selling pressure around the 12-month anniversary of listing, which is strongest when the 12-month anniversary occurs in July. These results are consistent with investors realizing their capital gains at the beginning of the financial year to delay payment of their CGT liability for 12 months. We also find that post-anniversary selling pressure declines as a function of institutional ownership, indicating the strength of the lock-in effect is correlated with the proportion of stock ownership by tax-sensitive investors. Moreover, our results indicate that the supply-side trading initiated by individual investors causes stock prices to fall. We also find that this result is present after accounting for the potentially confounding influence of the passing of escrow-expiration dates.