Ex-dividend stock price behavior: Evidence from a century of tax law changes

Scope and method of study. This study tests the tax clientele model of ex-dividend stock price behavior developed by Elton and Gruber (1970). Ordinary least squares (OLS) estimation is used to determine whether actual ex-dividend price drop ratios (PDRs) and market-adjusted returns (MARs) are related to dividend and capital gains tax rates in the theorized manner. The relationship between PDR and dividend yield is examined to determine whether it strengthens with wider tax differentials |td - tcg|. The Center for Research in Security Prices (CRSP) daily database is employed along with a sample of dividends paid by firms in the Dow Jones Industrial Average dating back to 1910. This study also develops a tax timing model showing that accumulated capital gains on a stock can weaken the ex-day effect. OLS regressions are used on the CRSP sample to test whether PDRs and MARs are related to recent changes in the stock price and to future changes in the capital gains tax rate tcg.; Findings and conclusions. Regression results confirm that PDRs are related to 1-td1-tcg and MARs are related to td-tcg1-t cg as expected when td and tcg are the tax rates faced by individuals. Regressions also show that PDRs are positively related to the dividend yield and that the strength of this relationship increases with the differential |td - tcg|. We conclude, therefore, that tax clienteles exist and that they influence ex-dividend stock price behavior. Regression results do confirm that PDRs and MARs are related to recent stock price changes. However, the relationship is unexpectedly stronger for high-yield stocks and for those with accrued losses. Therefore, we conclude that the tax timing model does not adequately describe the relationship between the ex-day effect and past returns. Finally, the results confirm that PDRs and MARs are related to future changes in tcg as hypothesized.