An empirical investigation of economic consequences of the Tax Reform Act of 1986

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Virginia Tech

This dissertation investigates the economic impact of the Tax Reform Act of 1986, one of the most far-reaching pieces of tax legislation in American history. The focus is on differential effects of the Act across industries. Event study methodology is used.

A model is created which links tax law provisions, firms’ cash flows, and securities returns. Hypotheses are developed for seven industries, based upon analysis of the provisions of the Act and upon reading of contemporaneous expert commentary. The sample consists of firms in those industries trading over-the-counter.

Evidence of an adverse impact for the Act as a whole on the steel and machine tool industries is found. It is concluded that the Tax Reform Act of 1986 caused a shift in economic resources away from those industries, and that shareholders of firms in those industries suffered losses of wealth. In addition, it is determined that the uniform capitalization rules for inventory adversely affected the retailing industry, and that the change in loan loss reserve rules adversely affected large banks. The latter set of findings emphasizes the substantive importance of tax accounting rules.

With regard to event study methodology, it is found that non-synchronous trading in over-the-counter stocks poses a severe problem when attempting to use the market model. A methodological modification suggested by Dimson is shown to be ineffective in dealing with this problem. Alternatives to the market model are identified, and are used in analysis.

Most significant reactions are found when abnormal returns are pooled over events, supporting an expectations-revision model of market reaction.