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

Many studies have used changes in tax laws to test the tax clientele theory (or long-term trading hypothesis) of Elton and Gruber (1970). Evidence supporting the tax effect is provided by several studies, e.g., Barclay (1987), Robin (1991), Lasfer (1995), Koski (1996), Lamdin and Hiemstra (1993), Poterba and Summers (1984), Bell and Jenkinson (2002), and Graham, Michaely, and Roberts (2003). However, Michaely (1991) finds the 1986 Tax Reform has no effect on the ex-dividend day price behavior. Michaely argues that individual investors are less influential while institutional and corporate traders play a more significant role on the ex-dividend day price behavior when transaction costs are lower. If the marginal investor is the corporate investor, who has preferential taxation of dividends over capital gains, then the PDR should be greater than one. Eades, Hess, and Kim (1984) find evidence consistent with the tax clienteles if the marginal investors are corporations. Elton, Gruber, and Blake (2005) revisit the tax clientele theory by studying taxable versus nontaxable closed-end funds. They find the PDR for nontaxable closed-end funds is larger than one, which is consistent with the prediction of the tax theory as dividend tax rates are lower than capital gains tax rates.

Several studies extend the work of Elton and Gruber (1970), to investigate how the interaction of taxes, transaction costs, and risk affects ex-dividend day price and volume. Michaely and Vila (1995) develop a dynamic model where ex-dividend day price and volume is a function of tax heterogeneity among traders, aggregate risk tolerance and risk of the individual stock around the ex-dividend day. Investors with differential tax-induced valuation of dividends and capital gains trade with each other around the ex-dividend day which can generate higher volume, higher excess return and a PDR less than one. In the Michaely and Vila model, the PDR reflects the relative tax rates of all market participants, not just the marginal trader's:

[3] E(PDR)= [bar.[alpha]] - X([[sigma].sup.2.sub.e] / K)/D = [bar.[alpha]] - v/D/P

where [bar.[alpha]] is the average of investors' relative tax preference of dividend to capital gains weighted by their risk tolerance; X is the aggregate demand for securities on the ex-dividend day; [[sigma].sup.2.sub.c] is the ex-dividend day variance; K is the aggregate risk tolerance and v is the risk premium.

Michaely and Vila (1995) also show that trading volume around the ex-dividend day is positively related to tax heterogeneity and negatively related to transaction costs and risk resulting from the deviation from an otherwise optimal portfolio. Empirical support for the dynamic tax-motivated trading hypothesis is provided by Michaely and Murgia (1995), Michaely and Vila (1996), Wu and Hsu (1996), and Dhaliwal and Li (2006).

Alternatively, the short-term trading theory is based on the premise that market pricing is dominated by short-term arbitrageurs. Kalay (1982) argues that short-term arbitrageurs would exploit any difference between the ex-dividend day price drop and the dividend until they are approximately equal. If transaction costs are zero, the ex-dividend day PDR should be equal to one since arbitrageurs have the same tax rate on their short-term capital gains as on dividends. If transaction costs are small, by assuming a simple form, the PDR should be bounded around one as

[4] 1 - [alpha][bar.P]/D [less than or equal to] PDR [less than or equal to] 1 + [alpha][bar.P]/D

where [alpha][bar.P] is the expected transaction cost of "a round trip." Lakonishok and Vermaelen (1983), Karpoff and Walkling (1988), Boyd and Jagannathan (1994), and Wu and Hsu (1996) provide support for this explanation.

An alternative microstructure explanation includes Bali and Hite (1998) who argue that the stock price drops less than the dividend because of price discreteness rather than taxes. Frank and Jagannathan (1998) argue that bid-ask bounce contributes to a price drop that is less than the dividend. However, Graham et al. (2003) and Jakob and Ma (2004) examine the effect of changes in price quotation and find no support for the microstructure explanation. Cloyd et al. (2006) show that both price discreteness and differential taxation affect ex-dividend day price behavior.

The 2003 Act significantly lowers the dividend tax rate and removes the preferential taxation of capital gains over dividends for individual investors. Hence the examination of the impact of the 2003 Act on the ex-dividend day share price, excess return, and volume behavior provides an opportunity to further examine the tax-based theories. Before the 2003 dividend tax cut, dividends are taxed more heavily than capital gains for individual investors. Individual investors, therefore, prefer capital gains to dividends while tax-exempt institutional investors are indifferent between dividends and capital gains, and corporate investors prefer dividends to capital gains. The 2003 Act increases the relative tax rates on dividends and capital gains for individual investors while other investors' relative tax rates are unchanged.

Because the PDR reflects the relative tax rate of the marginal investor, if the marginal investor is an individual investor, we expect the ex--dividend day PDR to be less than one before the 2003 Act. After the 2003 Act, tax rates for dividend and capital gains are equal for all individual investors. Hence equation [1] predicts that the PDR should increase to one. However, individual investors may still face a relative tax penalty on dividends as they can defer capital gains causing actual capital gains tax rates to remain lower than dividend tax rates even after the 2003 Act. (4) Thus the PDR may increase but still remain lower than one after the 2003 Act. Equation [4] of the dynamic trading clientele model also suggests that as long as individual investors participate in ex-dividend trading, the PDR should increase after the 2003 Act. The average of all investors' relative tax rates increases since the relative tax rates for individual investors increase and the relative tax rates for other investors such as institutional or corporate investors remain the same after the 2003 Act. Similarly, we expect a positive ex-dividend day excess return before the 2003 Act and a decrease in the excess return after the tax cut once dividends and capital gains taxes are equal for individual investors. This leads to our first hypothesis.

Hypothesis 1a: The PDR for dividend paying stocks should increase after the 2003 Act and become closer to one.

Hypothesis 1b: The ex-dividend day excess return for dividend paying stocks should decrease after the 2003 Act and become closer to zero.

The dividend clientele theory states that investors in high (low) tax brackets will prefer low (high) dividend paying stocks when there is preferential taxation of capital gains to dividends. Thus, the implied relative tax rates for marginal investors should decrease with dividend yields. As the PDR reflects the marginal investor's tax rate, it should be an increasing function of dividend yield. When the tax differential for individual investors disappears (or weakens due to the deferability of capital gains) after the 2003 Act, equation [1] predicts that the dividend clientele effect will disappear (or weaken). However, to the extent that transaction costs are important and dividend yield proxies transaction costs, the relation between the PDR and the dividend yield becomes uncertain. As dividend yield increases, more individual investors can participate in the ex-dividend day trading due to the lower transaction costs, which will change the aggregate average relative tax rate. (5) Thus, the relation between the PDR (or excess return) and dividend yield becomes an empirical question. Our second hypothesis follows.

Hypothesis 2a: The PDR should be positively correlated with the dividend yield before the 2003 Act and the correlation should weaken or disappear after the 2003 Act.

Hypothesis 2b: The ex-dividend day excess return should be positively correlated with the dividend yield before the 2003 Act and the correlation should weaken or disappear after the 2003 Act.

The dynamic trading clientele theory predicts a large abnormal volume (AV) around the ex-dividend day. Also tax-induced trading around the ex-dividend day results from the differential valuations of dividends versus capital gains among market participants. Because the 2003 Act not only removes the tax heterogeneity among individual investors, but also aligns the tax differential of individual investors with institutional investors and arbitrageurs, the gains of trading become smaller. With the reduction of tax--induced trading motives, ex--dividend day trading volume should decrease. This leads to our third hypothesis.

Hypothesis 3: The trading volume around the ex-dividend day should decrease after the 2003 Act.