Differential reactions to legislative signaling during the enactment of ERTA and TEFRA: An empirical investigation of market returns and volume

This study considers reactions by the investment community to information produced during the legislative processes that resulted in the Economic Recovery Tax Act of 1981 (ERTA) and the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Common stock returns were examined during periods surrounding critical events as a means of viewing the aggregate rational expectations of capital market participants regarding the impact of the respective legislations on shareholder wealth and company cash flows. Trading volume was investigated to gain insight into the extent to which market participants held homogeneous expectations about production cash-flow effects. Comparisons were made among samples of firms that had been partitioned along measures of capital intensiveness. The results provide evidence of differential price reactions within and across portfolios of firms of varying levels of capital intensiveness during the enactment process. As hypothesized, investor expectations about the effect of each of the legislations on noncapital-intensive firms were less widely held than expectations about their effects on capital-intensive firms. For ERTA, the results support the hypothesis that the legislation disturbed the degree of neutrality existing between capital-intensive and noncapital-intensive firms. No such conclusions may be drawn for TEFRA. Furthermore, a negative correlation of individual firm abnormal returns between the ERTA and TEFRA legislative periods for the capital-intensive firms suggests that, consistent with expectations, TEFRA, in effect, reversed the impact on neutrality induced by ERTA at the individual firm level.