Do Tax Law Changes Influence Ex-Dividend Stock Price Behavior? Evidence from 1926 to 2005
Whitworth, Jeff, Rao, Ramesh P., Financial Management
We test the Elton and Gruber model of ex-dividend stock pricing over a period spanning all US tax law changes since 1926. Our results indicate that price drop ratios ([DELTA]P/D) and ex-day returns are related to dividend and capital gains tax rates in the theorized manner. Consistent with tax clienteles, we also find that ex-day price movements of higher dividend yield stocks are driven more by corporate tax rates, while lower yield stocks are more influenced by personal rates. Finally, we demonstrate that the positive relationship between [DELTA]P/D and the dividend yield becomes stronger as the tax differential [[t.sub.d] - [t.sub.cg] widens.
On a stock's ex-dividend date, its price should drop by the amount of the dividend. However, a great deal of empirical research has documented that ex-day prices drop by significantly less than the dividend. Although a complete understanding of this anomaly still eludes us, the best known and most enduring of all theories is that different tax rates cause investors to value dividends and capital gains unequally. Elton and Gruber (1970) demonstrate that for a stockholder to be indifferent regarding the sale of stock just before the distribution (cure-dividend) or just after (ex-dividend), the price drop ratio (PDR) must be given by
[DELTA]P/D [P.sup.cum] - [P.sup.ex]/D = 1 - [t.sub.d]/1 - [t.sub.cg], (1)
where [P.sup.cum] and [P.sup.ex] are the cum- and ex-dividend prices, D is the dividend amount, and [t.sub.d] and [t.sub.cg] are the dividend and capital gains tax rates. It follows that [DELTA]P/D < 1 when [t.sub.cg] < [t.sub.d], as rates have usually been for individual investors. Elton and Gruber (1970) confirm that ex-day PDRs are, on average, less than one. However, they also find that PDRs generally increase with the dividend yield, suggesting that investors with lower ordinary tax rates [t.sub.d] prefer higher yield stocks, while those in higher tax brackets prefer lower yield stocks. Thus, their study provides economic reasoning and empirical evidence for a specific type of "dividend clientele" as originally suggested by Miller and Modigliani (1961).
There are few better opportunities to test theories about taxes than the natural experiment created by changes in a country's tax laws. While many studies have examined the ex-day phenomenon before and after specific US tax reforms, only a select few have examined the effect over long periods of time with the intent of understanding how price behavior varies across multiple changes in taxation. One such study is Eades, Hess, and Kim (1994) who plot the time series of abnormal ex-day returns (scaled by a volatility estimate) from 1962 to 1989 but fail to find a significant relationship between ex-day returns and changes in taxation. Using a different methodology that corrects for some data selection problems in the Eades, Hess, and Kim (1994) sample, Naranjo, Nimalendran, and Ryngaert (2000) present convincing evidence that ex-day returns are related to tax rates. However, this conclusion applies only to a carefully filtered sample of high-yield securities that are likely targets of corporate dividend capture after the introduction of negotiable commissions in May 1975.
There has been considerable variation in both personal and corporate tax rates throughout the last century. Unfortunately, prior studies of the time-varying behavior of ex-dividend stock prices have been limited by the availability of data. As illustrated in Figure 1, this study's primary contribution is to test the effect of taxes on the ex-day anomaly using a sample that extends continuously over a span of 80 years from 1926 to 2005. (1) Until recently, there has been no convenient source of daily stock price data prior to 1962, so few studies consider that era. This lack of historical analysis is unfortunate for at least two reasons. First, the pre-1962 period saw the highest personal tax rates, the largest differentials between dividend and capital gains rates, and the largest changes in tax rates (e. …