Ex-dividend day price and volume: the case of 2003 dividend tax cut.

INTRODUCTION

On May 28, 2003, President George W. Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003 (hereafter 2003 Act). The 2003 Act creates lower dividend and capital gains tax rates for individual investors. (1) Dividends were previously taxed at the ordinary income tax rate applicable to each taxpayer. However, under the 2003 Act, dividends received by an individual shareholder are taxed at the same rates that apply to capital gains. By removing the preferential tax treatment of capital gains over dividends for individuals, the 2003 Act provides a unique and significant event to study the impact of taxes and individual investors on the ex-dividend day stock price and trading behavior.

Research has focused extensively on ex-dividend day stock behavior. However, there is no consensus on the explanation for the widely documented phenomenon that the ex-dividend day price drops by less than the amount of the dividend. The tax-based explanation attributes this phenomenon to the preferential taxation of capital gains over dividends. Elton and Gruber (1970) proposed the tax clientele theory that the ex-dividend day price drop ratio (PDR) reflects the relative tax rates between dividends and capital gains. Extending the tax clientele theory, Michaely and Vila (1995) propose the dynamic trading clientele theory which argues that investors with differential tax-induced valuation of dividends and capital gains trade with each other around the ex-dividend day, so as to determine the ex-dividend day price and trading volume. The dynamic trading clientele theory combines tax motivations, transaction costs, and the risk tolerance of investors. Two alternative explanations that challenge the tax-based explanation include the short-term arbitrage theory proposed by Kalay (1982). He argues that arbitrageurs dominate the market and exploit any difference between the ex-dividend day price and the dividend such that any difference remaining is equal to transaction costs. Because arbitrageurs dominate the market in the short-term trading theory, tax changes that impact only individuals would not be predicted to impact the ex-dividend day PDR. Secondly, market microstructure arguments suggest that price discreteness (e.g., Bali and Hite, 1998) or bid-ask bounce (e.g., Frank and Jagannathan, 1998) causes the ex-dividend day price drop to be less than the dividend.

Our paper attempts to determine the role of taxes and individual investors in the determination of stock prices and trading volume around the ex-dividend day. We analyze the ratio of price drop to dividend on the ex-dividend day, the excess return and trading volume around the ex-dividend day before and after the 2003 Act. We examine stocks that pay regular taxable cash dividends, excluding closed-end funds, unit investment trusts, exchange traded funds (ETFs), American depository receipts (ADRs), and real estate investment trusts (REITs), between February 2001 and December 2005. By beginning our analysis in February 2001, we avoid the change in the market microstructure and transaction costs associated with stocks converting to decimal quotations through the end of January 2001. We also attempt to address whether individual investors have a significant effect on ex-dividend price behavior around the 2003 dividend tax cut.

Our results support the tax-based explanation for ex-dividend day price and trading behavior. With the removal of the preferential taxation for capital gains over dividends, the ex-dividend day PDR increases and moves toward one while the excess return decreases and moves toward zero. Our results show the dividend clienteles, either in the form of long-term buy and hold clienteles in the model of Elton and Gruber (1970) or in the form of trading clienteles in the model of Michaely and Vila (1995), weaken after the 2003 Act. Also with the reduction of the tax heterogeneity among investors, ex-dividend day abnormal trading volume among high dividend yield stocks significantly decreases after the 2003 Act consistent with a diminished motivation for tax-induced trading.

We also find significant effects associated with transaction costs on the ex-dividend day PDR, excess return and trading volume and risk on the ex-dividend day PDR, and trading volume. These findings are consistent with predictions of the dynamic tax-motivated trading clientele model of Michaely and Vila (1995). Furthermore, given that the 2003 Act only changes the tax rates for individual investors and not tax-exempt institutional investors or corporate investors, our results suggest that individual investors have a measurable effect on the ex-dividend day stock price and trading behavior.

Our study contributes to the literature in the following ways. First, we are among the few to analyze the recent tax cut and its associated effects on both the ex-dividend day price formation and tax-motivated trading activities around the ex-dividend day in a comprehensive setting. Although other studies analyze the 2003 dividend tax cut, many focus on the tax cut's impact on corporate dividend payouts or the markets reaction to the dividend tax cut (e.g., Amromin, Harrison, and Sharpe, 2006; Auerbach and Hassett, 2006; Chetty and Saez, 2006; and Howton and Howton, 2006). An exception is Chetty, Rosenberg, and Saez (2007) who analyze the effect of the 2003 dividend tax cut on ex-dividend day price and excess returns, but do not examine trading volume. Cloyd, Li, and Weaver (2006) focus on both the effect of price discreteness and the 2003 tax cut on excess returns and trading volume, but their post-Act time period is very short, ending in December of 2003. If individual investor taxes impact security prices, excess returns, and trading volume, this, in turn, can affect various facets of corporate finance, governmental revenue collection, and financial investments. Second, our study provides additional empirical support for the tax-motivated trading clientele model of Michaely and Villa (1995). Lastly, our study suggests that tax laws that influence the relative taxation of individual investors affect individual investors' trading behavior and the price formation of dividend paying stocks.

This paper is organized as follows. The first section describes the related literature regarding the ex-dividend day PDR, excess return and trading volume, and develops our hypotheses on the effect of the 2003 tax cut on the ex-dividend day market behavior. The second section describes our data and empirical methodology. The third section presents our empirical results and the fourth section concludes the study.

THEORY AND HYPOTHESES

Miller and Modigliani (1961) show that when a stock goes ex-dividend, its price theoretically should drop by the amount of the dividend. However, empirical research has widely documented that the price drop is less than the amount of the dividend. (2) There are many explanations for this phenomenon, including the differential tax treatment of capital gains and dividends.

Miller and Modigliani (1961) first propose the idea of dividend clienteles. They argue that while dividend policy may be irrelevant in determining a corporation's value, in imperfect capital markets in which dividends are taxed more heavily than capital gains, investors could form "clienteles" so that investors in high tax brackets hold low dividend yield stocks, while investors in low tax brackets hold high dividend yield stocks. Elton and Gruber (1970) argue that differential taxation of dividends and capital gains affects the behavior of prices on the day stocks pay dividends. In their model, marginal investors are long-term investors, who should be indifferent to selling on the cum-dividend day or ex-dividend day? In equilibrium, ignoring transaction costs and risk, the PDR reflects the ratio of differential tax rates between dividends and capital gains:

[1] PDR = [P.sub.cum] - [P.sub.ex]/D = 1 - [t.sub.d]/1 - [t.sub.c]

where

[P.sub.cum] is the cum-dividend day price,

[P.sub.ex] is the expected ex-dividend day price,

D is the dividend amount,

[t.sub.d] is the dividend tax rate and

[t.sub.c] is the capital gains tax rate.

The tax effect on the ex-dividend day share price can also be expressed in terms of excess return. The ex-dividend day realized return is equal to

[2] [P.sub.ex] + D - [P.sub.cum]/[P.sub.cum] = (1 - [P.sub.cum] - [P.sub.ex]/D) x D/[P.sub.cum] = [t.sub.d] - [t.sub.c]/1 - [t.sub.c] x D/[P.sub.cum]

as implied by the static tax clientele model of Elton and Gruber (1970). The excess return for the ex-dividend day is the realized daily return subtracted from the expected return.