This paper focuses on tax effects on stock price behavior around dividend dates. It has been observed that a share price of a stock usually drops when the stock becomes an ex-dividend. This behavior inhibits stock market traders from gaining a quick profit realized from purchasing shares and holding them for a day for the dividend. In most instances, it is usually difficult for traders to predict that a dividend would be paid. Consequently, a decline in share price may not be noticeable on a specific stock price quote. Many scholars have focused on the behavior of stock prices around ex-dividend dates because of multiple reasons (Boyd and Jagannathan 1994, 711-741). This behavior is an indicator of dividends and capital gains valuation, which is extremely important in corporate dividend policy. Given the interesting nature of this behavior, many academics have delved deeper to understand ex-dividend price behavior. Ex-dividend focuses on a record date for an investor to acquire favorable shares to get the dividend. It is usually three days for traders to settle. Therefore, an investor should buy a stock at least three days before the record date to be considered as a shareholder on the record date. Consequently, an investor purchasing shares less than three days before the record date will not get the dividend because the stock will be classified as an ex-dividend. The first study by Elton and Gruber in 1970 tested for possible tax effects on pricing based on a favorable treatment of capital gains relative to dividends. A price drop around dividends dates is extremely important for investors and researchers who have focused on deriving value and advancing theoretical explanations for such behaviors respectively.
Nearly all studies on the behavior of stock prices on ex-dividend days have established that stock prices reduce by less than the dividend (Blandón and Blasco 2011, 140-152). These findings have been consistent with tax effects. Elton and Gruber in 1970 demonstrated that taxes had a significant influence on investors. They noted that a decline in price on the ex-dividend day was related to a post-tax value of the dividend compared to the post-tax value noted in capital gains of the same day. Dividends are subjected to heavier taxes than capital gains in most instances. Theoretically, taxes may then influence choices made by investors, resulting in a fall in the stock price of less than the dividend. This decline in stock price can be applied to deduce minimal rates of tax.
It is observed that perfect capital markets should guarantee a similar price decline of a share compared to the dividend per share paid to investors on ex-dividend days. However, studies have consistently demonstrated that stock prices normally decline by not more than the dividend per share paid to investors. Blandón and Blasco (2011) noted that such results were consistent across all countries investigated, and they did not depend on time. As such, they concluded that the behavior was empirical consistency as noted in stock returns that had been classified as the ex-dividend day anomaly (Blandón and Blasco 2011, 140-152).
In Australia, for instance, researchers noted some fundamental behaviors in share market trade-off after the income tax law was reviewed. These observations were associated with dividends and capital gains (Brown and Walter 1986, 139-152). In this case, firms were to be taxed based on the company tax on each dividend paid to investors. The tax regime manifested itself on ex-the dividend day behavior of the country’s share prices. In North America, evidence generally suggested that share prices dropped by not more than the amount of the dividend on the day shares were quoted as ex-dividend. It was assumed that higher tax rates on dividends relative to capital gains, lack of information by investors and floor operators, and possible mistakes in predicting the ex-dividend days were responsible for the price drop (Brown and Walter 1986, 139-152). That is if tax rates were higher for dividends relative to capital gains and if short-term investors demonstrated indifference to the kind of after-tax earnings (capital gains or dividends), then a before-tax inclination for capital gains was obvious when share prices dropped by less than the dividend amount.
Some researchers have presented interesting findings concerning the observed behavior around dividend dates (Elton, Gruber, and Blake n.d, 1-25). According to Elton, Gruber, and Blake (n.d), several articles have emerged either supporting or interrogating the tax effect on ex-dividend dates and share price behavior. These critical articles have been classified into four groups. The first group of articles has conducted similar studies done by Elton and Gruber in other markets or the US markets during different periods. Other scholars have focused on the effects of changes on tax laws to determine the ex-dividend dates price drop (Chetty, Rosenberg and Saez 2005, 1-23). The third group of scholars acknowledges a change in price associated with ex-dividend less than the dividend but asserts that price change is restricted due to arbitrageurs’ short-term trading practices. Finally, other academics have observed that even when tax effects are not present, common stock share prices would still drop by not more than the dividend on the ex-dividend dates due to market microstructure elements (Connelly et al. 2008, 89-104). Some of the findings noted under this argument show that earlier works about tax effects and ex-dividend date price behavior could have been wrong and, therefore, this observation could have led the profession and traders (Elton, Gruber and Blake n.d, 1-25).
Discussion and Analysis
According to the tax effect argument, the dividend is taxed as income, and the price change is taxed as capital gains. These dividends attract relatively higher tax rates. Researchers now strive to demonstrate how tax is responsible for the price drop on ex-dividend days. In this regard, diverse tax regimes and laws, the different tax rates on specific dividends and capitals, and transaction cost and deduction have been attributed to tax effect on stock price behavior around dividend dates.
It has been generally observed that tax significantly affects dividends and capital gains. In addition, the tax effect is also felt on the market valuation dividends (Amiru and Biplob 2011, 21-23). Higher corporate tax than the personal tax would result in increased dividend yield and vice versa. As previously noted, the work of Elton and Gruber (1970) significantly influenced later studies on the tax effect on ex-dividend behavior. The researchers were interested in the clientele effect and investors’ marginal tax rate by assessing the mean price drop around the dividend dates based on data collected from the New York Stock Exchange. Data from firms that paid dividends on periods of interest were collected. Further, these companies also traded on ex-dividend dates and the previous day. Elton and Gruber developed an equation to depict the association between share prices and the dividend. Through this approach, the researchers were able to determine that the mean price drop as a fraction of the dividend paid was about 77.7%. A subsequent analysis proved that the price decline was noted relative to the dividend per-share amount. Based on this observation, Elton and Gruber (1970) concluded that investors could be categorized into dividend clienteles based on different tax rates and dividend yields offered. Further, they demonstrated that investors who were in the low tax segment held on their dividends than capital gains, but preferred high dividend yields. Conversely, investors found in the high tax bracket category were most likely to hold on to their dividends but preferred capital gains. Therefore, Amiru and Biplob (2011) observed that the drop in the ex-dividend stock price was not always similar to the dividend amount.
As cited in Amiru and Biplob (2011), some studies have found mixed results to support the observed stock behavior around dividend days. At the same time, no studies have demonstrated that the stock price declined by more than the dividend amount on the ex-dividend day. Specifically, evidence-based tax reforms suggest that taxation influences capital gains and dividends (Chetty, Rosenberg and Saez 2005, 1-23). Further, other studies had proved that the clientele effect was also an imperative source of influence on the price drop (Amiru and Biplob 2011, 21-23). By analyzing data obtained from the New York Stock Exchange, it was observed that indeed there was a significant positive association between dividend yield and expected returns. In the US and Canada, for instance, some researchers found out that tax differential resulted in the observed ex-dividend day behavior. On the other hand, in Hong Kong, for instance, it was noted that the tax effect was not applicable because dividend yields and capital gains were not taxed. However, if these capital gains and dividends were subjected to personal or corporate taxes, then the price drop was less than the dividend amount. It was further observed that ‘bid and ask’ played a significant role in the stock price movement where investors’ expectations generally reflected the stock price behavior.
Trading around ex-dividend days has also been explored. For instance, the work of Bali and Hite (as cited in Amiru and Biplob 2011, 24) demonstrates that stock prices tend to be discrete while dividends are minimal and continuous. Studies that assessed the price movement on ex-dividend dates found out that the price decline was related to tax differential between dividends and capital gains, and that comparatively high transaction costs subdued short-term trading around ex-dividend dates in stock markets analyzed (Connelly et al. 2008, 91). As such, the price drop realized was not only associated with the tax effect but also short-term trading activities around such periods.
The case of Japan is unique because of the tax regime, specifically dividend income tax for both short-term and long-term trading. There are no notable differences between short-term and long-term trading tax systems. Consequently, investors often focus on corporate trading (Amiru and Biplob 2011, 22-23). In addition, further studies have shown that tax or dividends did not indicate any direct impacts on the stock price behavior during ex-dividend dates.
Evidence on the stock volume shows that pressures related to selling and purchasing often escalate before and immediately after the announcement of the ex-dividend dates. Changes in the tax system, therefore, have noticeable influences on the stock price behavior and trading volume on ex-dividend dates. In the UK, for instance, after the year 1988, there was a change in income and corporate tax that significantly altered stock market behaviors. After the tax system change, a study by Laser 1995 (cited in Amiru and Biplob 2011) showed that there was a significant differentiation in taxation notable on dividends and capital gains. Positive impacts were related to differentiation, but they turned negative when there was no tax differentiation. The researcher also observed that there was a positive stock return on ex-dividend dates. Investors usually assessed their dividends and capitals gains before tax. Consequently, they understood that the stock prices would drop by a similar amount as the dividend. Relatively higher variation between capital gains and dividends based on the tax system led to higher returns on ex-dividend dates. All other studies conducted for stock markets and ex-dividend dates in Germany, the UK, Finland, and other countries showed positive correlations with the stock price behavior on ex-dividend dates after-tax rate modifications. Therefore, the available evidence supports the tax effect. In the US, for instance, before the confirmation of the income tax, a similar price drop was noted between the stock and dividend. On this note, much of the evidence covered so far demonstrates that the tax effect could be used to explain the stock price behavior on ex-dividend dates. However, some scholars have claimed that differential taxation might not be the only factor for stock price behavior observed during ex-dividend dates.
Some researchers had noted positive returns for nontaxable distributions that could not be explained by the tax effect (Connelly et al. 2008, 91). The highest yield price drop was significantly higher than a ratio of one for some researchers, and they noted that the tax effect argument could not explain such results. Consequently, they observed that tax-neutral short-term traders played a fundamental role on the ex-dividend dates. Specifically, trading volumes were relatively higher during ex-dividend days as institutional and corporate traders influenced stock prices around ex-dividend dates (Connelly et al. 2008, 91). Short-term trading effects were observed on excess return and transaction costs on ex-dividend dates. These observations show that other factors beyond the tax effect influenced the stock price behavior around ex-dividend dates.
Other studies cited in Connelly et al. (2008) also suggested that differential taxation was completely not related to ex-dividend day stock prices (Connelly et al. 2008, 91). Other studies have shown that market microstructure effects are responsible for the price decline by less than the value of the dividend around ex-dividend dates. Some rules on the NYSE, such as Rule 118 and AMEX Rule 132, have been linked with unusual returns during ex-dividend dates. These rules generally influence prices of limit purchase orders. In addition, other researchers have argued that price discreteness is the principal factor responsible for the drop in prices by less amount relatively to the dividend. As such, investors expect that the price drop will also be not more than the dividends even if differential taxation is not accounted for around the ex-dividend days. However, research of 2003 by Graham, Michaely, and Roberts has questioned influences of price discreteness because of the average increment in price ratios after the review of the tick size in the year 2011. Further, no variation was observed following the decline of the tick size.
Nevertheless, these opposing views had been reconciled by empirical evidence that suggested that both price discreteness and taxes significantly influenced stock prices on ex-dividend dates. This implies that no single factor or investor could be responsible for setting share prices on the ex-dividend dates. Some results for the period between 1996 and 1998 by Milonas, Travos Xiao, and Tan (2006) from the Chinese stock market indicated that there were price drops, but the amounts were relatively not significant compared with dividends (cited in Connelly et al. 2008). As such, these results were not consistent with the tax effect. Another study by Sarig and Tolkowsky (1997) (cited in Connelly et al. 2008) analyzed changes in prices around ex-dividend days for stocks trading on the Tel Aviv Stock Exchange. The results indicated that the drop in prices was less relative to the tax-adjusted dividend yields. The surplus returns were associated with an arbitrage opportunity, but there was no evidence to support short-term trading volume during ex-dividend days. The authors also observed that there were no bid-ask spreads in the market, and prices reflected several Israeli shekels. The price discreteness could not account for these results, indicating price drop ratios of less than one. Hence, the results showed there were other factors beyond the tax effect, market microstructure, and short-term trading that affected stock prices around ex-dividend day in the Israeli stock market. These factors were arbitrage opportunities.
Connelly et al. (2008) indicated that other factors, such as the quality of the judiciary, stock ownership concentration, and the extensiveness of management of profits had greater impacts on stock prices around the ex-dividend day. In addition, the researchers also found out that even after controlling other factors, the weighted average associated with relative tax rates was still present. In the end, these results suggested that information asymmetry, agency conflicts, and differential taxation of capital gains and dividends were all vital elements that influenced stock prices on ex-dividend dates in the global stock markets.
Conclusions, Implications, and Limitations
In conclusion, available studies offer empirical evidence to demonstrate that the tax effect is associated with a price drop around ex-dividend dates. Hence, such conclusions are relevant and valid for investors. At the same time, it is also imperative to recognize that several other results show that the tax effect alone cannot account for the price drop on ex-dividend days. These other factors are equally important as empirical evidence demonstrates. Changes related to the tax cut, for instance, have consistently demonstrated the tax effect on price movements on ex-dividend dates.
The research implication is that investors should not only focus on the tax effect but also consider other variables that tax differentiation cannot explain. It also presents further research opportunities for scholars.
The study’s limitation is that it is not original research. As such, the findings presented are based on previous works of other scholars. Nevertheless, it presents interesting findings on differential taxation and other related factors. Based on the conclusion derived, further studies should go beyond the tax effect and address other factors that could influence investors and subsequently affect price drops around ex-dividend dates.
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