THE LOCK-IN EFFECT OF CAPITAL GAINS TAXES: EVIDENCE FROM THE RJR NABISCO LEVERAGED BUYOUT WAYNE R. LANDSMAN* & DOUGLAS A. SHACKELFORD” Abstract - Inability to observe investors’ complete opportunity set has restricted prior analyses of capital gains taxes. This study overcomes these data limitations by examining involuntary capital gain real- izations arising from the 1989 RJR Nabisco leveraged buyout. Confidential share- holder records permit precise estimates of the shareholders’ tax bases. We find a negative correlation between price and tax basis for the shares sold. The direct evidence of investor tax-rationality is con- sistent with the lock-in effect and sup- ports assertions that the lock-in effect ex- erts upward pressure on the supply curve in equity acquisitions. INTRODUCTION This paper estimates the lock-in effect of capital gains taxes on the sale of RJR Nabisco stock during its 1989 leveraged buyout (LBO). Tests of the association between the price of the stock and shareholders’ tax bases at the time of *Kenan-Flagler Business School, Chapel Hill, NC 27599-3490 University sale are conducted using confidential shareholder records. We find a negative correlation between the price of the stock and the average tax basis of the shares sold during the 76 trading days from initiation to completion of the buy- out. The results are consistent with the lock-in effect and provide evidence that differences in capital gains taxes are a source of heterogeneous tendering re- sponses during an acquisition. The lock-in effect of the capital gains taxes is widely recognized as a transac- tion cost that arises from the deferral of taxation until realization.’ Understanding the magnitude of the lock-in effect is important for tax policymakers and tax planners. The lock-in effect is central to continuing policy discussions about the appropriate level of capital gains taxes and the taxation of accrued, but unreal- ized gains (“mark-to-market” account- ing). To the extent capital gains taxes re- strict portfolio management, deadweight costs arise from inefficient resource allo- cation and costly restructuring designed to reallocate resources without triggering capital gains taxes.2 Numerous studies have estimated the 245 National Tax Journal Vol. 48, no. 2, (June, 1995), pp. 245-259