This paper presents an empirical investigation of the effect of changes in capital gains tax rate on stock return volatility. We focus on two observable cross-sectional variations in the extent to which changes in capital gains tax rate affect return volatility — unrealized capital gains and dividend distributions. For both cross-sectional variations, we predict that the more stock returns are expected to be subject to capital gains taxation, the greater the increase in return volatility following a capital gains tax rate reduction. Consistent with these predictions, after passage of the 1978 and 1997 capital gain tax rate reductions, we find larger increases in the return volatility for more appreciated stocks than for less appreciated stocks and larger increases in the return volatility for non-dividend-paying stocks than for dividend-paying stocks, after controlling for an extensive set of firm characteristics, macroeconomic conditions, domestic and foreign stock market performances.
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