Taxes Matter in Canadian Financial Markets

December 29, 2005

In financial markets, relevant information is a premium. So when governments leak information regarding a proposed change in tax law, if taxes truly matter, you would expect the market to rapidly adjust. Such an example comes to us in the midst of the Canadian parliamentary election campaigns courtesy the Globe and Mail:

The RCMP has launched a criminal investigation into whether advance notice of Ottawa’s plans for income trusts leaked from the federal Liberal government, prompting election-trail calls for Finance Minister Ralph Goodale to resign.

Opposition parties, which have speculated that a leak last month fuelled insider trading, said the federal Finance Minister has no choice but to step aside until the probe is completed.

Trading of income trusts and related stocks spiked in the hours preceding a greatly anticipated announcement by Mr. Goodale on Nov. 23. The news, which helped shape the future market for trusts, was that Ottawa would not slap a tax on the investment vehicle, as feared, but would enact a politically popular cut in corporate dividend taxes to reduce an advantage that trusts have had in the market. (Full Story)

Because Canada has a drastically different legislative process from the U.S. and one where it is rather easy to get bills passed and into law once they are proposed, the Canadian markets took this announcement as an immediate indication that the law would nearly for certain change. And as you would expect if taxes matter, this created frenzy in the specific sector of the market that was to be most heavily impacted by the change in law. On the other hand, does news regarding possible changes in tax policy affect U.S. financial markets? A recent event study from the Federal Reserve claims that the U.S. financial markets did not react to news regarding possible changes in dividend tax law when the bills were being pushed through the legislative process in 2003. This has many asking the question of whether the market was saying that taxes don’t matter, or if there was some other factor explaining why there was no statistical relationship between financial market returns and favorable news reports (as determined by the study’s authors) of changes in dividend tax policy.

One of the main reasons for this study’s inability to show a relationship is most likely a result of the complex nature with which pieces of legislation in the United States are pushed through committee after committee in both chambers and subject to constant revision in both chambers and in the eventual conference committee before it is sent to the president for his signature.

Therefore, it is difficult to pinpoint exactly when the market would absorb the news of this bill’s winding path through Washington, and the likelihood that it would eventually become law. It could have absorbed part of the news during the campaign when President Bush promised to make this a policy if elected, or following the elections of 2000 and/or 2002. That is, the market could have had the expectation of these tax cuts being passed built into its value outside the event timeframe that was hypothesized by the study’s authors. Finally, as the Fed’s study rightly points out in its conclusion, there were many other factors influencing the market during the first half of 2003, specifically the war in Iraq.

You can read the Fed’s study here.


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