The paper examines the effect of the 2003 Act on investor behavior.
The net effect of the 2003 Act was to align the tax rates on capital
gains and dividends for individual investors, whereas previously
individual investors paid a higher rate on dividend income relative to
capital gains. We find that more corporations tend to pay dividends in
the post-Act period. We also find that dividend paying firms increased
the amount of dividends per share, but the dividend yield tends to
decrease in the post-Act period. Analyzing tax relevance versus tax
irrelevance on ex-dividend day market behavior, our findings support the
tax-based view that the relative taxation of dividends versus capital
gains does affect ex-dividend day price and trading behavior. We find
that the ex-dividend day PDR increases and the excess return decreases
in the post-Act period.
We also find evidence that overall dividend clienteles weaken after
the 2003 Act as evidenced by a decrease in the relation between the
dividend yield and the ex-dividend day PDR (or excess return).
Consistent with the trading clientele theory, we find a significant
effect of transaction costs on the ex-dividend day PDR and excess
returns, and a significant effect of risk on the PDR. As the tax
heterogeneity among investors is reduced after the Act, tax-motivated
trading around the ex-dividend day declines significantly for high
dividend yield stocks. We also find that trading volume is negatively
related to risk and transaction costs and positively related to dividend
yield although the result appears to be driven by high dividend yield
stocks. We interpret our results to be generally consistent with the
dynamic trading clientele model of Michaely and Vila (1995). The
ex-dividend day stock price and trading behavior is jointly affected by
relative taxation of dividend versus capital gains, risk, and
transaction costs. Given that the 2003 Act only affects the relative tax
rates for individual investors, our results suggest that individual
investors play an important role in ex-dividend day price formation and
trading activities.
Acknowledgments
We appreciate the helpful comments and suggestions from anonymous
referees, Ravi Jain, and seminar participants at the 2006 Financial
Management Association meetings and the University of Nebraska-Lincoln.
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Yi Zhang & Kathleen A. Farrell
University of Nebraska-Lincoln, Lincoln, NE 68588-0490
Todd A. Brown
Stephen F. Austin State University, Nacogdoches, TX 75962
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