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Effect of Capital Gain Taxation on Stock Market Performance – Evidence from Stock Market in

Pakistan

ContentsViber/WhatsAPP 00923004604250....................................................................................................1

Uk LandLine +441252594901............................................................................................................1

1. Introduction.............................................................................................................................................4

1.1 Research Overview............................................................................................................................4

1.2 Problem Statement............................................................................................................................5

1.2.1 Research Significance..................................................................................................................6

1.3 Research Questions...........................................................................................................................6

1.4 Research Objectives...........................................................................................................................7

1.5 Research Hypothesis..........................................................................................................................7

1.6 Schematic Diagram............................................................................................................................8

2. Literature Review....................................................................................................................................8

2.1 Theory of Consumption...................................................................................................................10

2.2 Impact of Capital Gains Tax on Stock Market Performance.............................................................12

2.1 Theoretical Framework....................................................................................................................13

3. Research Methodology..........................................................................................................................14

3.1 Research Design...............................................................................................................................14

3.2 Data Collection Methodology..........................................................................................................14

3.2.1 Variables.......................................................................................................................................15

3.3 Data Analysis...................................................................................................................................15

Bibliography...............................................................................................................................................17

Team of Sparkles Soft Comprise on Exceptional Writers for Professionally Crafted Papers.......19

Viber/WhatsAPP 00923004604250..................................................................................................20

Uk LandLine +441252594901..........................................................................................................20

1. Introduction

The research title proposed is

“Effect of Taxation on Stock Market Performance – Evidence from Stock Market in Pakistan”

Within this section, an overview of this research issue is presented. The core focus is on

highlighting the significance of the research along with the aims and objectives of the proposed

research. This chapter will be laying down the basic foundational understanding of the research

issue upon which the later parts of this document will be building.

1.1 Research Overview

Through the proposed research, the specific impact of capital gains taxes on the stock market

performance in Pakistan will be considered. The field of considering impacts of taxation on

stock market performance is extensive and therefore in order to narrow the research issue

down for an in depth exploration, the increasingly significant case of capital gains taxes on

Pakistani stock markets will be considered.

In the budget presented by Ishaq Dar, the Finance Minister of Pakistan in June 2015 for the

Fiscal Year 2015 – 2016, it proposed that a 7.5% Capital Gains Tax be imposed on the sales of

shares that have been held for any period longer than 2 years (Rana, 2015). Furthermore it was

proposed that for shares sold within one year should be taxed at a higher rate such that the

existing Capital Gains Tax of 12.5% should be increased to 15% thus representing a 20%

increase in the capital gains tax for those shares sold within one year and finally the sale of

shares of holding period between 1 to 2 years be increased from 10% to 12.5% (Rana, 2015).

The report by Rana (2015) on the presentation of Fiscal Budget 2015 – 2016 further noted that

currently the shares sold after a holding period of two years are exempted from capital taxation

however the administration has focused on increasing the state revenues and thus has focused

on introducing a new slab that could capture the longer term gains that the stock investors are

making. The motivation to increase the levels and rates of capital gains taxation was to improve

the returns to the state from the strong performance of the Stock Exchanges in the country. For

example KSE’s market capitalization in 2014 peaked to 7.1 trillion whereas from those only 4.5

billion capital gains taxes were collected thus implying that the state is not benefiting from the

high performance of the stock exchanges in the country as it needs to especially considering the

social and economic needs of the country as a whole.

Theoretically, increasing the taxation on a highly profitable economic entity seems a beneficial

idea for collecting state revenues however this benefit is only one side of the coin when

considering a multi faceted and complex economic situation such the performance of stock

markets. A well established stock market has been theorized by (Levine & Zervos, 1998) to

promote long term economic growth and development as its allows from increased liquidity in

the economy as well as increased capital accumulation in the economy. This means that from

restricting the stock market performance there is likely to be a negative impact on the

economic growth and development. This then reduces the projected gains to the state of

increased taxation of stock market gains.

Given this economic and financial trade off for the overall economic and financial performance

of a country, it becomes critical to analyze how the increases in Capital Gain Taxes in Pakistan

are likely to affect the performance of the stock markets in the country. The point of focus here

is that if the cost of reduced stock market performance is high than the benefit from increased

taxes, then in the longer run the economy will be worse off thus implying that the increases in

taxes was an adverse financial strategy by the state.

1.2 Problem Statement

The basic research problem that the proposed research seeks to investigate upon is how, given

its multidimensional impacts, capital gain taxation impacts the stock market performance

within the Pakistani economy. This is a complex and critical issue to be analyzed because on

one hand the increase in taxes from the capital returns are expected to lower the disposable

income and the market liquidity levels for the investors and on the other hand, the increased

state revenue from increased taxation is expected to be invested at a macro-economic level

which in turn will improve the business growth and performance levels and thus the

performance of the stock market. How this relationship exists within the economic axes of

Pakistan is what will be focused upon by the proposed research.

1.2.1 Research Significance

The Ministry of Finance in Pakistan along with the Federal Bureau of Revenue has been gearing

up its performance in terms of tax collection (Ansari, 2015) and has been taking strict actions

against the tax defaulters in the country. The focus of the country is to streamline the revenue

generation processes such that the government can reduce its reliance on foreign assistance

and external debt financing for the economic development, budgetary processes and social

needs of the country. The agenda behind the increases in taxation is affective however relating

this to the findings of the capitalist school of thought, the increase in taxation is likely to

increase the deadweight loss and the social burden in the economy which in the longer run has

a cost of its own on the economic and financial efficiency of the country (Kelly & Williams,

2015).

The proposed research is significant because it is highlighting this issue in the context of

upcoming economic developments in Pakistan and there theorized impact on the overall

performance of the country and its financial institutions. Given the global integration of stock

markets, a high performing stock market is likely to attract significant degree of investment into

the country however taxing the individuals or institutional gains then is likely to negatively

affect the investment inflow. Through the proposed research it will be seen how the taxation

rates changes in an economy influence the performance of the stock markets in the country.

Currently the amount of literature available in the context of Pakistan fiscal structure and stock

market performance is limited and thus this research will be adding considerably to knowledge

and thus the understanding of Pakistani dynamics. The results of the proposed research are

expected to be significant for stock market investors, brokers and the financial policy makers in

the country in terms of allowing them to make better strategies and optimized portfolio given

the changes in taxations structures.

1.3 Research Questions

The proposed research will be answering the following research questions:

1. What is the conceptual and theorized relationship between taxation and stock market

performance?

2. How does the performance of stock market in a country impact upon its economic

performance?

3. What are the impacts of capital gain tax on the market performance of KSE and LSE

markets in Pakistan?

4. How can the government and stock investors reach an optimized solution on the basis

of taxation and economic gains as mediated by the stock market performances?

1.4 Research Objectives

The core aim of the proposed research is to,

“Analyze the impact of corporate gain taxation on the performance of Stock Markets in

Pakistan”

In order to achieve this research aim, the following research objectives have been crafted:

1. To explore the impacts of taxes on the stock market performance of an economy

2. To elaborate upon the influence of stock market performance on the economic

performance of a country

3. To analyze how changes in the capital gains taxes in Pakistan impact the performance of

KSE and LSE

4. On the basis of the primary data findings and the secondary data findings to proposed

recommendations to the policy makers and stock investors in the country as to how

they can optimize the mutual benefits

1.5 Research Hypothesis The following hypotheses will be empirically tested through:

H1: Announcements of increase in capital gains has a significant negative impact on the

perceptions of the investors

H2: Increase in capital gains taxes significantly reduce the disposable income of the investors

H3: Increase in capital gains taxes significantly reduce the reinvestment rate of the investors

H4: Increase in capital gains taxes has a significant negative impact on stock market

performance

1.6 Schematic Diagram The schematic diagram for this research proposal is

2. Literature Review

The literature available on theorizing the impact of taxation on various economic elements is

vast and thus in order to move order and analyze the same situation in the context of Pakistan,

it is important that the available literature be first taken into consideration.

According to (Grubel , 2001) capital gains tax is a tax on the profit that an investor achieves

from selling their asset on a profit. The basic premise behind this tax is that given the beneficial

economic and political conditions provided by the state, the owner of the asset was able to

make the profit and thus now needs to share the returns with the government as a part of

governmental revenue.

The literature available in finance has focused significantly on the preferences of investors and

their trading behaviors in regards to the capital and current currents. One school of thought

proposes that individuals prefer liquidity and gains today rather than gains tomorrow with less

liquidity today. Following that school of thought business organizations are focused on

Literature Review

Theoretical Framework

Research Method

developing effective dividend policies through which they can attract investment towards the

equity of the organization. Furthermore according to this theory, investors demand a higher

return for their investments when the holding period is longer.

The liquidity preference theory proposed by the Keynesian school of thought notes that if the

liquidity of assets decline, the assets have to provide the investors with a higher rate of return

in order to compensate for the decline in liquidity (Carvalho, 2010). This is also explained by the

model as under:

What this means is that when the liquidity of the organization declines in terms of the money

received from selling the stock the investor would require a higher rate of performance from

the stock in order to continue investing. If the tax lowers the returns significantly, the

opportunity cost of investing in the same stock for the investor will be significantly higher and

thus the focus of the investor will be on shifting the portfolio’s structure. Liquidity preference

has been an important concern in the analysis of stock market performance (Nneji, 2015). One

set of researchers analyze the relationship between liquidity and return with the conclusion

that increased liquidity in the stock market fosters growth of market prices by creating

speculative price bubble (Caginalp, Porter, & Smith, 2000); (Hussan, Porter, & Smith, 2008).

According to this perspective, factors that lead to decrease in the liquidity in the stock market

have an adverse influence on the price bubbles and therefore the growth of the market is

expected to be limited. This then means that taxes that result in lower liquidity with the market

players are likely to reduce the rate of market growth thus implying the applicability of Liquidity

Preference Theory as a mediator between CGT and Stock Market Performance.

It has been reviewed that the reactions of market to the announcements of changes in the

capital gains. In order to the relationship between the capital gains taxes on the market price

and trading volume a correlation analysis was conducted (Clinch & Odat, 2012). The findings of

the research suggest that the impact of capital gain taxes on price movements and trading

volumes is higher when the levels of anticipated inflation are higher.

2.1 Theory of Consumption In the General Theory by Keynes it has postulated that the aggregate consumption in the

economy is a function of the disposable income that the consumers have (Mankiw , 2008). This

relationship between the income levels and the consumption in the economy is critical

considering that the consumption is the largest component of GDP measure and thus a decline

in the consumption is likely to impact the overall performance of an economy.

The consumption function as proposed by Keynes is illustrated as under:

As can be seen, the consumption function consists of the following elements:

i) Average Propensity to Consume (APC): According to the consumption function, as the income

rises, the APC as given by C / Y declines.

ii) Marginal Propensity to Consume (MPC): According to the model, the higher the income the

higher will be the consumption.

iii) The consumption expenditure will increase or decrease with the changes in income however

these changes will not be proportional

This consumption function is important to be studied in the context of taxation and stock

market performance because through increased taxations the income available to the investors

is likely to decline through which both the reinvestment opportunities and the consumption of

the investors will decline.

2.2 Impact of Capital Gains Tax on Stock Market Performance

Aurangzeb (2012) notes that: taxation is an indispensible element in the share trading system

as this is one of the information that the investors use while conducting their share trading and

investment processes. In this regards, it has been explained that it is critical that an efficient

taxation system be developed not only to fortify the authenticity and the administration quality

of the government but also to accomplish better financial results from the targeted share

exchanges (Heggstad & Kari, 2011). In this context however an important aspect is noted by

(Shafiullah & Al Mukit, 2012) who says that,

"Development of new organizations or an economy would not be conceivable without

accessibility of stocks and improvement of monetary markets".

According to this view it is important that the stock markets be well operative for the economy

to develop further. The taxes on the free share market mean that the returns and the

investment preferences of the investors are likely to change. Apart from this given the taxation,

the liquidity preferences and the resultant payout policies of the organizations are likely to be

influenced which in the long run will have a strong impact on the economic and financial power

of the country.

The impacts of capital gains tax on the trading decisions of the shareholders have been of

interest to both the scholars and the policy makers given the significant financial impact

expected from the two (Lin & Zeng, 2005). In order to conduct their research Lin and Zeng

(2005) conducted a research on the Canadian Stock Markets and find that the stock trading

volumes initially increase immediately before the announcement of tax rate change and then

takes up to 5 days after the announcement to increase so as to allow the investors to get used

to the information and decide upon their plan of investment.

An interesting element noted by (Blouin, Raedy, & Shackelford, 2000) is that tax treatment of

the abnormal stock returns is different in the US S&P 500 market. However the researchers find

little consistency in the results which means that further research is required on the issue.

This means then that through increased taxes the consumption of the investors will decline

thus having a negative impact on the overall financial performance of the stock market and

economic performance of the country.

2.1 Theoretical Framework The proposed research will be working to analyze the consistency of the following theoretical

diagram:

3. Research Methodology

3.1 Research Design

In order to conduct the proposed research an empirical research will be conducted. The first

step of the research will be to conduct an in depth review of literature on the issues of capital

gains taxes, determinants and consequences of stock market performance and the relationship

between taxation structures on the performance of the stock markets in a country. In this

review, examples from various international stock markets and their reactions to the changes in

the capital gains taxation rates will be studied. Through this discussion a conceptual framework

identifying the important variables mediating the relationship between stock market

performance and taxation rates will be extracted.

The second step of the research design will be to collect data on the stock market performance

and taxation rates from Pakistan. For this purpose as mentioned the selected stock exchanges

are the Lahore Stock Exchange and the Karachi Stock Exchange.

3.2 Data Collection Methodology

Data for the proposed research will be collected both through secondary and primary collection

methods.

Primary data will be collected through interviews of 50 stock investors of the LSE and KSE in the

country. The detailed interviews will be focused upon gauging the perception of the stock

investors regarding the stock market movements as influenced by the changes in capital tax

gains. The perceptions of the investors are likely to play a strong role in how the markets will

react and thus through these interviews, a solid informational foundation will be created. Apart

from this interview data will be collected from 50 brokers in the KSE and LSE. These brokers are

the front end people who are closely connected to the changes in the market and are well

aware of how the markets react as a result of macroeconomic or policy changes in the country

and thus are suitable in terms of extracting information on the research issue.

Moving further, secondary data will be collected from the historical performance of the

selected stock markets in Pakistan. The time period taken for this purpose is from 2000 – 2015.

Similarly changes in the Capital gains Taxation Rates will be collected form the FBR database for

the same period.

3.2.1 VariablesFor the proposed research the following are expected to be the indespendent variables:

i) Capital Tax Gains

ii) Current Tax Gains

iii) Number of Days of Announcement

iv) General Stability of the Stock Market

The following are expected to be the dependent variables:

i) Stock Market performance measured through KSE 100 index performance and LSE 100 index

performance over the selected time period.

3.3 Data Analysis

Once the primary and secondary data is collected, the data will be analyzed by developing a

structural equation model in analyzing the impacts of CGT changes on the performance of the

stock markets. This model will be created and analyzed under the light of the available

literature and will be focused on highlighting the variables that influence the relational impact

of taxes on the stock market performances. Precedence for the use of the structural equation

models and OLS regression techniques is available in majority of the research analyzing the

impacts on stock market performance of external variables e.g. (McMillan, 2014) and (Hearn,

Piesse, & Strange, 2010).

In order to further achieve the research objectives, the research will be moving forward to

develop an optimizing framework through which the gains to the state and the investors can be

maximized. Again, in order to develop this framework, assistance from the available literature

and financial models will be taken.

Bibliography1. Ansari, W. (2015, May 20). FBR to take strict measures against tax defaulters. Retrieved

September 10, 2015, from Customs Today : http://www.customstoday.com.pk/fbr-to-take-strict-measures-against-tax-defaulters/

2. Aurangzeb , D. (2012). Factors Affecting Performance of Stock Market: Evidence from South Asian Countries . International Journal of Academic Research and Social Sciences, Vol. 21 , 267 - 285.

3. Blouin, J., Raedy, J. S., & Shackelford, D. (2000). Capital Gains Taxes and Equity Trading: Empirical Evidence . NBER Working Paper No. 7827, 1 - 40 .

4. Caginalp, G., Porter, D., & Smith, V. (2000). Overreactions, momentum, liquidity, and price bubbles in laboratory and field asset markets. Journal of Psychological Financial Marketing, Vol. 1 , 24 - 48.

5. Carvalho, F. (2010). Liquidyt Preference and Monetary Economics. New York: Routledge .

6. Clinch , G., & Odat, M. (2012). Capital Gains taxes and the Market responses to Public Announcements in an Indexation based tax regime. Journal of Comptemporary Accounting and Economics, Vol. 8 (2), 53 - 63 .

7. Grubel , H. (2001). International Evidence on the Effects of Having No Capital Gains Taxes. New York : The Fraser Institute.

8. Hearn, B., Piesse, J., & Strange, R. (2010). Market liquidity and stock size premia in emerging financial markets: The implications for foreign investment. International Business Review, Vol. 19 (5), 489 - 501 .

9. Heggstad, O., & Kari, K. (2011). The tax systems in Mozambique. Tanzia : Pearson.

10. Hussan, R., Porter, D., & Smith, V. (2008). Thar she blows: can bubbles be rekindled with experienced subjects? American Economic Review, Vol. 98 , 924 - 937 .

11. Kelly, M., & Williams, C. (2015). Business . New York: Cengage Learning .

12. Levine , R., & Zervos, T. (1998). Stock Markets, Bank, and Economic Growth . The American Economic Review , 537 - 558 .

13. Lin, H., & Zeng, T. (2005). Stock market Reactions and Capital Gains Tax: Evidene from the 1985 Canadian Lifetime Capital Gains Expemtions. Review of Accounting and Finance, Vol. 4 (2), 149 - 164 .

14. Mankiw , G. (2008). Macroeconomics. New York: McGraw Hill .

15. McMillan, D. (2014). Stock return, dividend growth and consumption growth predictability across markets and time: Implications for stock price movement. International Review of Financial Analysis, Vol. 35 , 90 - 101.

16. Nneji, O. (2015). Liquidity shocks and stock bubbles. Journal of International Financial Markets, Institutions and Money, Vol. 32, 132 - 146.

17. Rana, S. (2015, May 28). Budget 2015 - 2016: Goverrnment Proposes higher Capital Gains Tax on Traded Securities. Retrieved September 10, 2015, from The Express Tribune: http://tribune.com.pk/story/893401/budget-2015-16-govt-proposes-higher-cgt-on-traded-securities/

18. Shafiullah, D., & Al Mukit, M. (2012). Impact of Monetary Policy on Post Crash Stock Market Performance: Evidence from Dhaka Stock Exchange . Journal of Business and Economics, Vol. 9 (2), 28 - 36 .

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Viber/WhatsAPP 00923004604250

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