Capital Gains Lock-in and Share Repurchases
Jonathan B. Cohn
McCombs School of Business
University of Texas at Austin
Stephanie A. Sikes
The Wharton School
University of Pennsylvania
June 23, 2011
The authors appreciate helpful comments from Andres Almazan, Aydoğan Altı, Daniel Beneish, Sugato
Bhattacharyya, Matthew Billett, Andriy Bodnaruk, Brian Bushee, John Core, Dan Dhaliwal, Amy Dittmar, John
Graham, Jennifer Juergens, Li Jin, Denys Maslov, Ed Maydew, William Moser, Jeff Pontiff, Jana Raedy, Josh Rauh,
Michael Roberts, Cathy Schrand, Doug Shackelford, Clemens Sialm, Laura Starks, Sheridan Titman, Scott
Weisbenner, and workshop participants at Boston College, Duke University, Indiana University, University of
Maryland, University of North Carolina-Chapel Hill, University of Pennsylvania, Penn State University, Rice
University, University of Texas at Austin, and University of Texas at San Antonio; participants at the 2009 Texas
Finance Festival, the Texas Tax Readings Group, the University of Arizona tax doctoral seminar, the 2009
American Accounting Association Annual Meeting, the 2009 Southeast Summer Accounting Research Colloquium,
the 2009 European Finance Association Meeting, the 2009 Lone Star Finance Symposium, the 2009 Duke/UNC Fall
Camp, and the 2011 American Finance Association Meeting. We also thank Denys Maslov for excellent research
assistance and Brian Bushee for sharing his institutional investor classifications.
Capital Gains Lock-in and Share Repurchases
Anecdotal and empirical evidence suggest that price is an important determinant of firms’ share
repurchase decisions. We investigate a factor that could affect a firm’s stock price around a
repurchase and thus the number of shares a firm repurchases. We predict that tax-sensitive
investors’ reluctance to sell stocks for which they have unrealized capital gains reduces the
supply of a firm's shares available in the market, and thus raises the price at which the firm can
repurchase its shares. Using unique data on the tax-sensitivity of a sample of institutional
investors, we find evidence consistent with our prediction. Moreover, as expected, the negative
relation between capital gains lock-in and the number of shares repurchased is only present when
the supply of a firm’s shares is inelastic.
Many factors drive corporate share repurchase decisions. Chief among them is price. A
recent survey of corporate financial executives finds that a firm’s current stock price is the single
most important factor in its share repurchase decisions (Brav et al. 2005).1 The price at which a
company can repurchase its shares is determined by shareholders’ willingness to sell them. If
shareholders are willing to supply an unlimited quantity of a firm’s shares at a single price that
reflects the firm’s fundamental value – that is, if the supply of a firm's shares is perfectly-elastic
– then supply considerations should not impact repurchases. However, there is substantial
evidence that supply and demand in the market for corporate shares is not perfectly-elastic.2
This raises an important question: Given the price sensitivity of firms when repurchasing their
shares, do limits to the supply of a company’s shares cause it to repurchase fewer shares than it
We address this question by examining the effect of a well-documented tax-based constraint
on the supply of shares. An investor’s gain on a stock is subject to taxation only when the
investor realizes the gain by selling the stock. This gives taxable investors an incentive to delay
selling stocks for which they have unrealized gains.3 Consistent with this argument, prior
studies find that taxable investors refrain from selling shares when they would face large capital
gains tax bills upon doing so, an effect typically referred to as capital gains “lock-in.”4 This
withholding of shares with unrealized gains reduces the supply of shares available in the market.
1 See, for example, Dann (1981), Vermaelen (1981), Bartov (1991), Comment and Jarrell (1991), Ikenberry,
Lakonishok and Vermaelen (1995), Stephens and Weisbach (1998), and Dittmar (2000).
2 For evidence that supply of/demand for firms’ shares is inelastic, see Scholes (1972), Shleifer (1986), Holthausen,
Leftwich and Mayers (1987), Loderer, Cooney and Drunen (1991), Kandel, Sarig and Wohl (1999), Kaul, Mehrotra
and Morck (2000), Kalay, Sade and Wohl (2004), Schultz (2008), and Ahern (2010).
3 Delaying the realization of gains is potentially beneficial because unrealized gains are set to zero upon the death of
the investor, because the investor can offset gains with any future capital losses, and because short-term gains are
typically taxed at a higher rate than long-term gains.
4 See, for example, Feldstein, Slemrod and Yitzhaki (1980), Landsman and Shackelford (1995), Reese (1998), Klein
(2001), Ayers, Lefanowicz and Robinson (2003), Blouin, Hail and Yetman (2009), Ivkovic, Poterba and Weisbenner
(2005), Jin (2006), Ayers, Li and Robinson (2008), and Dai et al. (2008).
If limits to supply are an important driver of repurchase decisions, then a capital gains lock-in-
driven supply reduction should have a negative effect on repurchases.
We test this prediction by examining the relation between a firm's repurchases and the
unrealized capital gains of its shareholders, and find broadly supportive evidence. We
conservatively estimate that firms would have repurchased 2.5 percent, or $38 billion, more of
their shares between 1987 and 2008 absent the lock-in effect. The negative effect of capital
gains lock-in on repurchases is stronger when the long-term capital gains tax rate is higher (i.e.,
when selling stocks with unrealized gains exposes investors to greater capital gains tax). This
not only supports our conclusions, but also suggests that the anticipated increase in the long-term
capital gains tax rate from 15 percent to 20 percent in 2012 could have a negative effect on the
tendency of firms to repurchase shares.
We implement our tests using data on the holdings of a set of institutional investors whose
sensitivity to taxation we can reliably identify. Specifically, we use unique data on the client
composition of investment advisers to classify these advisers as tax-sensitive or tax-insensitive,
depending on the tax-sensitivity of their clients. We classify advisers as tax-sensitive if over 50
percent of their clients are high net-worth individuals and as tax-insensitive if over 50 percent of
their clients are individuals with tax-deferred accounts or tax-exempt entities (i.e., pensions, state
and local governments, and/or charitable organizations).5 Using Section 13(f) quarterly holdings
data, we estimate each investment adviser’s quarter-end unrealized capital gain in each stock that
5 We collect data on clienteles from Form ADV, which all investment advisers registered with the Securities and
Exchange Commission (SEC) must file. We describe the data in more detail in Section II.
6 Since investors can offset realized gains in a stock with realized losses on other stocks, we focus on "uncovered"
capital gains - unrealized gains that cannot be offset by realizing losses on other stocks in the portfolio.
If firms respond to a lock-in-driven supply constraint by repurchasing fewer shares, then tax-
sensitive investors’ unrealized gains should have a negative effect on share repurchases.
However, repurchases could be related to investors' unrealized gains for reasons other than the
effect of capital gains lock-in on the supply of shares. For instance, investors with large
unrealized gains may have an impetus to sell shares in order to rebalance their portfolios. In
addition, investors could exhibit the “disposition effect,” defined as the tendency to realize gains
at a quicker rate than losses (Shefrin and Statman 1985).7 Either of these effects could increase
the supply of a firm's shares if the shares have appreciated and therefore have a positive effect on
repurchases. In other words, these effects bias against us finding our predicted negative relation
between capital gains lock-in and shares repurchases.
To isolate the capital gains lock-in effect, we exploit the difference in the tax-sensitivity of
the two groups of investors in our sample. Only tax-sensitive investors should exhibit the lock-in
effect in their decisions of whether to sell a stock. Consistent with this argument, Jin (2006)
shows that tax-sensitive institutions are less likely than tax-insensitive institutions to realize
capital gains using a sample similar to ours. Thus, any effect of unrealized capital gains on
repurchases due to capital gains lock-in should exist only for unrealized gains of tax-sensitive
investors, and not for unrealized gains of tax-insensitive investors. Consider a dollar of
unrealized capital gains in the holdings of an investor in a firm that is considering a stock
repurchase. If these unrealized gains are in the holdings