The Effects of Dividend Taxes on Equity Prices: A Re-examination of the 1997 U.K. Tax Reform

Transcription

1 WP/07/204 The Effects of Dvdend Taxes on Equty Prces: A Re-examnaton of the 1997 U.K. Tax Reform Stephen R. Bond, Mchael P. Devereux, and Alexander Klemm

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3 2007 Internatonal Monetary Fund WP/07/204 IMF Workng Paper European Department The Effects of Dvdend Taxes on Equty Prces: A Re-examnaton of the 1997 U.K. Tax Reform Prepared by Stephen R. Bond, Mchael P. Devereux, and Alexander Klemm 1 Authorzed for dstrbuton by Albert Jaeger August 2007 Abstract Ths Workng Paper should not be reported as representng the vews of the IMF. The vews expressed n ths Workng Paper are those of the author(s) and do not necessarly represent those of the IMF or IMF polcy. Workng Papers descrbe research n progress by the author(s) and are publshed to elct comments and to further debate. We re-examne the extent to whch personal taxes on dvdends are captalzed nto the equty prces of domestc frms, usng data from around the tme of the 1997 U.K. dvdend tax reform, whch removed a sgnfcant tax credt for an mportant group of nvestors: U.K. penson funds. The tax-adjusted CAPM suggests that the mpact should depend on an average of dvdend tax rates across all nvestors, and that U.K. penson funds should reduce ther holdngs of the prevously tax-favored asset: U.K. equtes. Gven that U.K. penson funds are small relatve to the total sze of the world captal market, a small open economy-type argument mples that the man effect of the reform would be to reduce U.K. penson funds ownershp of U.K. equtes, wth lttle mpact on ther prce. We present evdence whch s consstent wth these hypotheses. We dscuss why prevous research (Bell and Jenknson, 2002) reached a dfferent concluson. JEL Classfcaton Numbers: G12, G23, G35, 20 Keywords: Tax reform, dvdends, stock market. Authors E-Mal Addresses: steve.bond@economcs.oxford.ac.uk; mchael.devereux@sbs.ox.ac.uk; aklemm@mf.org 1 Stephen Bond s at Nuffeld College, Oxford and the Insttute for Fscal Studes (IFS), Mchael Devereux s at the Sad Busness School, Oxford, and IFS, and Alexander Klemm s n the European Department of the IMF. The authors thank Tm Besley, John Norregaard and Jm Poterba for helpful comments.

4 2 Contents Page I. Introducton...3 II. The Taxaton of Dvdends n the U.K...7 III. A Smple Portfolo Model...8 IV. Emprcal Implcatons...13 V. Data...15 VI. Results...16 A. Bell and Jenknson (2002) Replcaton...16 B. Drop-off Ratos and Dvdend Yelds...17 C. Evdence on the Dstrbuton of Drop-off Ratos...18 D. Further Evdence on Tmng...19 VII. Conclusons...21 References...23 Tables 1. Regresson Results Obtaned by BJ and Replcaton Regresson Results by Dvdend Yeld Quntles Regresson Results by Pre-reform Dvdend Yeld Quntles Share of Negatve Drop-off Ratos Estmated Drop-off Ratos by Year/half-year Share of U.K. Equtes n Total Equty oldngs of Penson Funds, Long-term Insurance Companes and Unt Trusts Benefcal Ownershp of U.K. Equtes...28 Fgures 1. FTSE 100 Index, July 2, Drop-off Ratos, The Dstrbuton of Estmated Drop-off Ratos...30

5 3 I. INTRODUCTION Recent years have seen mportant reforms of dvdend taxaton n several OECD countres. In 2003, the USA moved away from a pure classcal system, ntroducng preferental personal tax rates for dvdend ncome. In 1999, Ireland moved n the opposte drecton, replacng a partal mputaton system wth a classcal system, n whch dvdend ncome s taxed at the shareholder s full margnal ncome tax rate. The operaton of mputaton systems n European Unon countres has been held to be nconsstent wth the EU Treaty n a seres of rulngs by the European Court of Justce, generally nvolvng dscrmnaton aganst ether foregn shareholders or foregn corporatons. Several EU countres have modfed or abandoned ther mputaton systems as a result. Both Germany and the U.K. now tax dvdends n a smlar way to the current US system, wth dvdends subject to personal ncome tax, but not taxed at the shareholder s full margnal ncome tax rate. 2 In Ireland, Germany and the U.K., revenue rased from these dvdend tax ncreases has been used to fnance reductons n the corporate ncome tax rate. For any assessment of these reforms, an mportant queston s whether dvdend taxes have any sgnfcant effect on corporate nvestment decsons. The publc economcs lterature suggests two dstnct reasons why dvdend taxaton may have lttle relevance for corporate nvestment. The new vew or tax captalzaton hypothess accepts that dvdend taxes wll be captalzed nto share prces, but emphaszes that taxes on dvdends wll stll have no effect on the cost of captal or nvestment, f the margnal source of fnance used by frms s retaned earnngs and the dvdend tax rate s constant. The classcal statements of ths result are n Kng (1974) and Auerbach (1979), and the ntuton s straghtforward. Suppose that dvdend ncome s taxed at rate m, so that the shareholder gves up net ncome of $(1 - m) to fnance an nvestment of $1 from retaned earnngs. When the return from the nvestment say $(1 + r) s pad out as a dvdend, the shareholder receves $(1 - m)(1 + r), so that the post-tax rate of return (r) s the same as the pre-tax rate of return. For nvestment fnanced from retaned earnngs, the dvdend tax acts as a cash flow tax, and s neutral wth respect to the nvestment decson. Of course, ths argument does not hold f the margnal source of fnance s new equty, and the return s pad out at least partly n the form of a dvdend. 3 It s possble therefore that dvdend taxaton acts as a dsncentve to nvestment by mmature frms, whch are more relant on new equty fnance. 4 But snce most nvestment s undertaken by mature corporatons and snce most of ther nvestment s fnanced from retaned earnngs, dvdend taxaton s expected to have only a lmted effect on aggregate nvestment. 2 For legal reasons lnked to blateral tax treates, the U.K. stll formally operates a dvdend tax credt. For domestc shareholders ths s equvalent to ncome tax at a preferental rate, and the remanng tax credt has neglgble value for foregn shareholders. 3 Edwards and Keen (1984) made more precse the result that neutralty holds as long as the margnal source of fnance s the same when the nvestment s made and when the returns are pad to shareholders (and as long as the dvdend tax rate s constant). 4 See, for example, Snn (1991). Recent papers that test predctons of the 'new vew' nclude Auerbach and assett (2002, 2005), Chetty and Saez (2005) and Chetty, Rosenberg and Saez (2007).

6 4 A dfferent argument that leads to broadly the same concluson s the tax rrelevance vew, whch suggests that dvdend taxes have lttle or no effect on share prces. As frst stated by Mller and Scholes (1978), the argument s that share prces are determned by the tradng decsons of large, tax-exempt fnancal nsttutons lke penson funds, that do not pay tax on ther dvdend ncome. If the margnal shareholder does not pay the dvdend ncome tax, nether stock market valuatons nor value-maxmzng nvestment decsons should be nfluenced by dvdend tax rates. A related argument has been made n the context of small open economes by Boadway and Bruce (1992). In ther model, the rate of return on domestc nvestment s determned ether by the rate demanded by foregn shareholders (for captal mporters), or the rate avalable on outbound nvestment (for captal-exporters). Both of these rates are determned on the world market and are unaffected by domestc taxes on dvdends. Boadway and Bruce do not explctly consder the market value of equty, snce they assume that the domestc frm maxmzes the utlty of the domestc shareholder, rather than the market value. owever, where the frm s partly owned by foregn nvestors, these foregn nvestors are effectvely the margnal shareholders, and the frm s market value s ndependent of domestc taxes on dvdends. Fuest and uber (2000) also assume that foregn nvestors are the margnal shareholders. The assumpton that share prces depend only on the tax treatment of one class of nvestors s dffcult to reconcle wth asset prcng theores based on optmal portfolo allocaton by rsk-averse nvestors. owever the fnance lterature provdes a model that at least n a small open economy context leads to broadly smlar predctons as the model of Boadway and Bruce (1992). Ths s the tax-adjusted captal asset prcng model (CAPM), frst set out by Brennan (1970), n whch dfferent nvestors may face dfferent tax rates on dvdend ncome. Ths approach makes no assumpton about the dentty of the margnal shareholder. In contrast, all nvestors can be margnal n the sense of beng just wllng to hold the equty at the rulng market prce, even though tax rates may dffer both across nvestors and across assets. Ths s possble because they are also concerned about the rsk they bear by holdng rsky assets. In equlbrum, an nvestor wth a lower tax rate on a specfc asset wll tend to hold more of that asset, but at the cost of holdng a less dversfed, and hence more rsky, portfolo. In ths model, the effect of dvdend taxes on share prces depends on an average of tax rates across all nvestors. It does not matter that shares n a specfc asset may be held predomnantly by one group of shareholders; the relatve ownershp of a partcular asset across dfferent types of nvestors s rrelevant. What does matter s the relatve total wealth of dfferent nvestors. In the context of a small open economy, ths mples that dvdend ncome taxes on domestc nvestors are lkely to be rrelevant to the tax captalzaton effect. If frms choose nvestment to maxmze ther stock market valuatons, ths agan mples that domestc dvdend taxaton wll have lttle or no effect on nvestment. 5 5 If most stock market wealth s controlled ether by (domestc or foregn) tax-exempt nsttutons or by foregn nvestors who can avod payng ncome tax on dvdends pad by domestc frms, ths would further (contnued)

7 5 The 1997 dvdend tax reform n the U.K. provdes an nterestng opportunty to test these predctons. As we explan n more detal n secton II, before ths reform, U.K. penson funds and nsurance companes managng penson-related assets could reclam part of the corporate ncome tax pad by frms on the underlyng profts, when they receved dvdends pad by U.K. companes. These rebates cost the U.K. government around 5bn per annum, equvalent to about 20 percent of U.K. corporaton tax revenue. Before 1997, U.K. penson funds alone owned around 30 percent of all U.K. equtes, and held approxmately three quarters of ther equty holdngs n U.K. companes. These rebates were abolshed by the new Labour government n ts frst Budget n July The posttax value of a gven cash dvdend pad by a U.K. frm to a U.K. penson fund fell by 20 percent, whle other shareholders both U.K. and foregn were largely unaffected by ths reform. Extendng the argument of Mller and Scholes (1978) that share prces are largely determned by the valuaton of domestc fnancal nsttutons that own the largest shares of these assets to ths U.K. settng, Bell and Jenknson (2002) suggested that ths reform of U.K. dvdend taxaton caused a sgnfcant fall n the value of the U.K. stock market. To support ths clam, they studed the behavor of share prces on ex-dvdend days the day on whch the owner of the share ceases to be enttled to a recently announced dvdend payment. If U.K. penson funds were the margnal nvestors, then the exdvdend day fall n the market value of a U.K. company payng 100 of cash dvdends should have been 125 (ncludng the rebate of underlyng corporaton tax) before the 1997 reform and 100 after the reform. Equvalently the drop-off rato (the change n the market value expressed as a proporton of the cash dvdend) should have fallen from 1.25 to 1, a fall of 20 percent. In contrast, the tax-adjusted CAPM predcts that ths reform of U.K. dvdend taxaton should have had essentally no effect on ether share prces or drop-off ratos. U.K. penson funds would be expected to reduce ther holdngs of U.K. equtes, as the tax advantage that nduced them to bear more U.K.-specfc rsk was elmnated. But snce U.K. penson funds are small relatve to the world captal market, ths portfolo reallocaton should have lttle or no effect on U.K. share prces. As a frst step towards consderng more detaled emprcal evdence, t s useful to revew movements n the U.K. stock market ndex on and after the announcement of the 1997 tax reform. The FTSE 100 ndex s presented n Fgure 1, between 1995 and As s well known, there was consderable volatlty n the stock market durng ths perod, wth the ndex almost doublng between 1995 and 1999 before fallng back. The date of the 1997 tax reform s marked by the vertcal lne. If equty valuatons had followed the Bell- Jenknson predcton, then, ceters parbus, there should have been a fall of around 20 percent n the value of the ndex on the announcement of the reform. Clearly, ths dd not happen. Instead the ndex contnued to rse. It s concevable that other announcements n Gordon Brown s frst Budget may have overshadowed the dvdend tax reform. owever, mply the Mller-Scholes vew that dvdend taxaton n general s largely rrelevant for stock market valuatons. owever ths stronger mplcaton s not needed for the hypotheses we nvestgate n ths paper.

8 6 t s dffcult to thnk of precedents for announcements of changes n economc polcy producng the requred 20 percent rse n the stock market, at least n advanced economes. Nevertheless, Bell and Jenknson (2002) fnd that the mean drop-off rato for lsted U.K. companes fell sgnfcantly after ths tax reform, although ther central estmate s from around 1.05 to We confrm ther fndng n our emprcal analyss; however we do not share ther concluson that U.K. share prces are determned by the valuatons of U.K. penson funds. Our doubts about ther concluson are based both on the theoretcal clam that one type of shareholder should be the margnal nvestor n a market where the same assets are held smultaneously by dfferent nvestors facng dfferent tax rates; and the methodologcal concerns about nferrng the mpact of dvdend taxes on share prces from fluctuatons n the mean drop-off rato, that have been hghlghted recently by Chetty, Rosenberg and Saez (2007). To support ths, we present a more detaled emprcal study of the behavor of ex-dvdend day drop-off ratos n the U.K., both around the 1997 tax reform and over a longer perod. Whle the mean drop-off rato dd fall sgnfcantly n the second half of the 1990s, further analyss reveals that ths fall was assocated wth a sharp ncrease n the proporton of observatons where the share prce rose on the ex-dvdend day, generatng a negatve value for the drop-off rato. It s not clear how ths development could be related to the dvdend tax reform. A smlar pattern was observed n the late 1980s, wth the mean drop-off rato beng low and the proporton of observatons wth negatve values beng hgh n the perod after the 1987 stock market crash. There were no changes to the tax treatment of U.K. penson funds that could explan these patterns n the late 1980s. In lne wth Chetty, Rosenberg and Saez (2007), we conclude that the mean drop-off rato n the U.K. s too volatle for short term fluctuatons around tax reforms to provde relable evdence on the effects of dvdend taxaton on the stock market valuaton of frms. 6 In a related paper, we nvestgated more drectly whether the 1997 U.K. dvdend tax reform affected the nvestment behavor of U.K. companes, and found no sgnfcant effect. 7 Our fndngs n ths paper are consstent wth that result, but also provde an explanaton for why there should be no effect of U.K. dvdend taxaton on U.K. corporate nvestment. At least n the U.K. context, ths does not seem to be explaned by the standard new vew argument, whch would mply a sgnfcant tax captalzaton effect on share prces. Rather, t appears to reflect the sze of the U.K. and the openness of ts captal market. Consstent wth the tax-adjusted CAPM n a small open economy settng, there s no sgnfcant effect of domestc dvdend taxes on U.K. share prces, and hence no mpact on nvestment by U.K. companes. 6 Chetty, Rosenberg and Saez (2007) document smlar volatlty over tme n the behavor of the mean drop-off rato n the US. Interestngly ther estmates show that there was also a sharp fall n the mean dropoff rato n the US n the second half of the 1990s, although there was no smlar tax change n the US that would explan ths development. 7 Bond, Devereux and Klemm (2007).

9 7 In the next secton we present a bref summary of the U.K. dvdend tax regme before and after the 1997 reform. Followng that, n Secton III we outlne a smple verson of the Brennan (1970) tax-adjusted CAPM model, whch serves to hghlght the features of the market whch are mportant n determnng prces. In Secton IV, we summarze the emprcal predctons of the model and set out how we mplement emprcal tests. Secton V presents the data, and Secton VI the results. We conclude n Secton VII. II. TE TAXATION OF DIVIDENDS IN TE U.K. We brefly summarze the man elements of the dvdend tax regme both before and after From the early 1970s untl 1999, the U.K. operated a partal mputaton system. On payng a cash dvdend, U.K. frms were oblged to pay a proporton of the dvdend n tax: Advance Corporaton Tax (ACT). Subject to restrctons (prncpally that the dvdend dd not exceed U.K. taxable proft), the ACT could be credted aganst the man corporaton tax charge, and thus generally only affected the tmng of corporaton tax payments. In addton, however, U.K. shareholders could also clam a credt aganst the U.K. ncome tax due on the recept of the dvdend. In general, ACT was charged at the basc rate of ncome tax (20 percent for dvdend ncome n 1997) on the grossed-up dvdend (.e. the cash dvdend plus the ACT). ence basc rate shareholders were deemed to have pad tax n full on any dvdends receved, and consequently dd not have to pay any further tax. gher rate taxpayers, whose margnal tax rate was 40 percent, had to pay addtonal tax. For a 100 cash dvdend, they had to pay tax on the grossed-up value of 125,.e. a total of 50, but they could offset aganst that the 25 tax credt, leavng them wth another 25 to pay. The crucal element of the tax regme for our purposes s that tax-exempt U.K. shareholders were enttled to clam a tax rebate equal to the ACT pad by the frm. Just before the tax reform n 1997, ths was worth 25 percent of the cash dvdend (equvalent to 20 percent of the grossed-up dvdend). As noted earler, the cost of payng ths rebate pror to 1997 was around 5 bllon per year, around 20 percent of U.K. corporaton tax revenue. The 1997 tax reform abolshed ths cash rebate for U.K. penson funds, and the pensonrelated assets of U.K. nsurance companes. Other tax-exempt shareholders chartes, non-tax-payng ndvduals, and holders of tax-advantaged personal equty plans were unaffected. Some tax treates also provded for non-u.k. shareholders to receve part of the tax credt worth approxmately 6percent of the cash dvdend. They too were unaffected by the 1997 reform. 8 A more detaled descrpton of the tax system s provded n Bond and others (2007), where we nvestgate the mpact of the 1997 reform on company dvdend payments and nvestment.

10 8 In 1999 the system was further reformed. The cash rebate was now abolshed for most other non-tax-payng ndvduals, 9 ncludng those foregn shareholders that used to receve some beneft. 10 The credt rate was halved to 10 percent, but U.K. tax-payng shareholders were unaffected, as ncome tax rates on dvdend ncome were also reduced. At ths tme, ACT was also abolshed, and new payment arrangements were ntroduced for companes payng corporaton tax. III. A SIMPLE PORTFOLIO MODEL We present a smple verson of the one perod tax-adjusted CAPM model of Brennan (1970) whch has been wdely used to study the case of shareholders wth heterogeneous tax rates. 11 The am here s to dentfy the effects of dfferences n tax rates, not only across nvestors, but also across assets for an ndvdual nvestor. There are a large number, N, of nvestors. Investor has an endowment of X, whch s dvded between two rsky assets, and W, and a rsk-free asset. Investor holds shares at prce p n asset, W shares at prce q n W, and the remander, B = X -p -qw, n the rsk-free asset. Dvdends from and W, denoted D and D W, are taxed at rates m and m W respectvely, net of any dvdend tax credts. Captal gans are taxed at rate z for both assets. Interest ncome from the rsk-free asset s taxed at rate m. Dvdends are assumed to be known, but the prces of the rsky assets at the end of the perod, denoted P % W and P %, are stochastc. Random varables are denoted wth a tlde ther expected values at the start of the perod are shown wthout the tlde. The end-of-perod wealth of nvestor s Z %, where ( 1 ( 1 )) Z% = + r m B ( P% ( 1 m ) D z( P% p) ) W ( P% W W W ( 1 m ) D z( P% q) ) W ( 1 ) ρ ( % γ ) W ( % W γ W ) = X + z B + G + D + G + D W (1) where G % s the stochastc captal gan on asset eg. G% = P% p, where r s the rskfree nterest rate, 9 Chartes receved temporary compensaton for ths loss. olders of Indvdual Savngs Accounts contnued to receve credts untl For foregn shareholders ths was acheved by halvng the tax credt to 10percent and applyng a wthholdng tax of 10percent, rather than by formally abolshng the credt. 11 See, for example, Ltzenberger and Ramaswamy (1979, 1980, 1982), Gordon and Bradford (1980), Auerbach (1983) and Mchaely and Vlla (1995).

11 9 ρ = ( 1 m ) 1 z r (2) s the tax-adjusted dscount rate of nvestor, and γ = ( 1 m ) 1 z and γ W = W ( 1 m ) 1 z (3) are the tax dscrmnaton varables of nvestor for assets and W respectvely. Investors choose and W to maxmze ϕ V = Z var ( Z% ) (4) 2 where φ s a rsk averson parameter. The form of φ s mportant: we dscuss two specal cases below. The expected value of Z %, denoted Z, s equal to the expresson n (1), wth the stochastc captal gans terms replaced by ther expected values. The varance of Z % s where covarance ( Z) = ( z) ( σ + W σw + W σw ) var % 1 2 (5) 2 σ, and 2 σ W are, respectvely, the varances of P % and W P %, and σ W s the Assumng an nteror soluton n whch the nvestor smultaneously holds all three assets, the nvestor s demand for each asset can be derved from the frst order condtons for and W, whch are: G + γ D pρ Wσ = W 2 2 ϕ( 1 z) σ σ G + γ D qρ σ W = W W W W 2 2 ϕ( 1 z) σw σw and (6) We can use these demand equatons to solve for the equlbrum prces, and rates of return. Suppose there are, n aggregate, and W shares n the two rsky assets respectvely. Defne λ = 1/(1-z )φ so that a hgher λ mples ether lower rsk averson or a hgher captal gans tax rate. Aggregatng the frst expresson for over N nvestors and rearrangng mples

12 10 G λ + D λγ p ρλ σ W = = = N W 2 2 = 1 σ σ λ G + γ D pρ σ WW 2 2 σ σ (7) where γ and ρ are weghted averages: γ γ λ = λ ρλ and ρ = λ (8) (9) An equvalent expresson holds for asset W. Alternatvely, we can express the equlbrum expected return to purchasng a share n, as G + γ p D 2 σ + σww = ρ + p λ (10) Ths takes a famlar form: the expected return s equal to the weghted average return on the rsk-free asset, plus an adjustment for rsk. The defnton of the weghted average return s dscussed below. The rsk adjustment depends on the varance of the end-ofperod prce of the asset tself and the covarance wth the end-of-perod prce of the other rsky asset, where the weghts on these two terms depend on ther relatve sze n the overall market. If asset s suffcently small relatve to W, then only the covarance term matters. Ths expresson s consstent wth Brenan s (1970) model of the CAPM wth personal taxes and has been the subject of extensve emprcal testng. 12 The portfolo choce of nvestor depends on hs own tax rates relatve to that of other nvestors. Specfcally, 2 ( ) D ( ) ( )( p q ) γ γ σ γ γ σ D W W W λ W W λ = λ σwσ σw ρ ρ σw σw (11) Clearly, nvestor wll tend to hold more or less of, dependng on whether hs tax parameter, γ s above or below the weghted average, γ. If, for example, γ = 1.25 and γ = 1, as was broadly the case for U.K. penson funds holdng U.K. equtes before 1997, then penson funds would hold more of ths asset. ow much more depends on the 12 See, for example, Ltzenberger and Ramaswamy (1979, 1980, 1982), Black and Scholes (1974), Mller and Scholes (1982), Kalay and Mchaely (2000).

13 11 rsk of the two assets and the nvestor s rsk averson, λ. For example, the more rsk averse s the nvestor (the lower λ ), the less would be the tendency to have addtonal holdngs of ths asset n response to favorable tax treatment. Of course, the tax treatment of the other assets also affect the holdngs of. Advantageous tax treatment of the return from W or the rsk-free asset relatve to a weghted average of other nvestors (.e. W W γ > γ or ρ > ρ ) would reduce holdngs of by nvestor. To examne the effects of dfferental taxaton further, t s necessary to examne the weghted average tax rates. It s useful to smplfy by assumng that all nvestors face the same rate of captal gans tax on all assets, n whch case the weghted averages depend only on the rsk averson parameter, φ : γ γ / ϕ ρ / ϕ = and ρ =. 1/ ϕ 1/ ϕ (12) Now consder two specal cases: () All nvestors have the same degree of rsk averson: φ = φ for all. In ths case, λ = N /1 ( z) ϕ and γ and ρ reduce to unweghted averages across all nvestors. One mplcaton of ths s that ndvdual holdngs of the rsky assets do not depend on the ntal endowment. Consder (11), but settng the tax rates faced by all nvestors on each asset to be the same. Then the second term s zero and = /N: all nvestors hold the same number of shares n. Any dfference n endowments s reflected only n the holdng of the rsk-free asset. Of course, holdngs of the rsky assets are affected by tax rates; but the fact that holdngs dffer across nvestors s not reflected n the constructon of the average tax rates, whch are unweghted. Ths s because each nvestor s at a margn and s equally lkely to trade part of the holdng. A smple alternatve to ths s: () Rsk averson dffers only across endowments: φ = φ/x. 13 In ths case, the weghts for γ and ρ are ntal endowments: γ γ X ρ / X = and ρ =. X X (13) Ths s more ntutve; abstractng from dfferences n taxes agan, holdngs of rsky assets are exactly proportonal to the endowment snce λ / λ = X / X. Note though that agan the weghted tax rates do not depend on the holdngs of each asset: ndeed, the 13 Of course t s straghtforward to allow for dfferences n preferences as well as endowments. For example, φ = θ /X where θ represents ndvdual preferences.

14 12 weghts for and W are the same. Suppose nvestor has a tax advantage from and hence holds a greater proporton of hs nvestment n compared to other nvestors. It s not the case that the weghted average tax rate for dsproportonately reflects s tax rate. As n the prevous case, all nvestors are at the margn; the dfference from the prevous case s that snce holdngs are proportonal to the endowment, a wealther nvestor would trade more n response to a change n, say, the expected end-of-perod prce. As a result, hs tax rate s weghted more. It s nterestng to note the consequences of taxes varyng only across nvestors, so that W W W m = m = m and hence γ γ = γ γ = ρ ρ for all nvestors. In ths case, nvestor would hold more or less than the weghted average ( λ / λ ) holdng, dependng on whether he faced a relatvely hgh tax rate (that s, whether γ > / < γ ), 2 and on the sgn of W 2 σwd σwd ( pσw qσw ). Even n ths case, t s therefore generally not true that all nvestors would dvde ther portfolo across assets n the same way. ence the weghts for constructng the average tax rates would stll not be equal to relatve holdngs of the ndvdual assets. owever, fnally note that from (10), the market valuaton of each asset depends only on the tax rates appled to that asset. An mplcaton of ths s that expresson (10) s equally vald n consderng the prce mplcatons of the recent US dvdend tax reform, even though that tax reform appled to dvdends from all equtes. The US tax reform reduced the dvdend tax rate for US personal nvestors. The effect of ths on US equty prces depends on how the average tax rate across all nvestors n US equtes was affected. If the wealth of the group of US taxpayers affected was suffcently small, relatve to the wealth of tax-exempt US nvestors and non-us nvestors, then agan as a frst approxmaton, there would be lttle or no mpact on US equty prces. 14 We note three qualfcatons to ths smple model. Frst, we have assumed an nternal soluton n whch all nvestors hold all assets. Consder the ntroducton of a subsdy to a group of nvestors on the ncome from asset. Ths wll nduce those nvestors to swtch ther holdngs n favor of. They wll contnue to do so ether up to the pont at whch, at the margn, the gan from the subsdy s exactly offset by the addtonal rsk they bear by movng away from an optmally dversfed portfolo ths s characterzed by (6) or untl those nvestors have swtched all ther holdngs to asset. In practce we do not observe nvestors holdng only one form of asset, and so (6) seems the most lkely equlbrum. Second, as argued by Mller and Scholes (1978), t may be the case that tradng costs deter some nvestors respondng to small changes n the prces or expected returns from partcular assets. If only a subset of all nvestors respond to new nformaton, then at the 14 Chetty, Saez and Rosenberg (2007) provde more detal on ths US tax reform, and emprcal evdence on ts mpact on US equty prces.

15 13 margn, t s only the tax rates of those "margnal" nvestors whch wll be reflected n the weghted average tax rates. The relevance of ths observaton for examnng the U.K. tax reform depends on whether the weght of U.K. penson funds should be hgher than f all nvestors were taken nto account. Ths s a key emprcal ssue whch we address below. Thrd, ths model gnores tradng around the ex-dvdend day. To prevent a tax-favored nvestor holdng only asset cum-dvdend and then dversfyng ex-dvdend, t s necessary to ntroduce some cost to ths tradng strategy. For example, there may be transacton costs, or a rsk of unfavorable underlyng prce movements around the exdvdend day. Mchaely and Vlla (1995) develop a theoretcal model n whch exdvdend day tradng s allowed but s endogenously lmted. Lasfer (1995) presents emprcal evdence that ex-dvdend day returns n the U.K. are not sgnfcantly affected by short-term tradng. We follow Bell and Jenknson (2002) n assumng that an analyss of U.K. ex-dvdend day returns can n prncple dentfy the mpact of dvdend taxaton. IV. EMPIRICAL IMPLICATIONS Ths model suggests two emprcal hypotheses about the mpact of dvdend taxes. Frst, the overall effect of dvdend taxes on share prces reflects the weghted average tax rate of all nvestors,. What does ths suggest about the mpact of the 1997 U.K. γ dvdend tax reform on U.K. share prces? Even takng the second specal case above, U.K. penson funds control only small proporton of the total wealth nvested n all markets. Any change n ther tax rate s therefore lkely to have a neglgble effect on U.K. equty prces. Thus: Proposton 1 The 1997 tax reform should have lttle or no effect on the prces of U.K. equtes. We test ths proposton below usng the standard technque of analyzng drop-off ratos. When a share goes ex-dvdend, margnal shareholders are ndfferent between ether sellng the share at the cum-dvdend prce, thus forgong the dvdend, or keepng the share and thus recevng the dvdend. Denote the cum-dvdend prce by P c, the exdvdend prce by P ex, and the dvdend by D. Then followng Elton and Gruber (1970), and usng (10), we have P c - P ex = D (14) or P c - P ex / D = γ (15) The term on the left hand sde of ths expresson s the drop-off rato: the fall n the prce expressed as a proporton of the dvdend. The term on the rght hand sde s the tax dscrmnaton varable, descrbed above. The drop-off rato can therefore be used to estmate the average value of the tax dscrmnaton parameter whch determnes the share prce.

16 14 In practce, we measure P c at the end of tradng on the last day the share trades cumdvdend, and P ex at the end of tradng on the frst day the share trades ex-dvdend. Clearly, the dfference between these two prces wll reflect not only the dvdend payment, but all other news about the value of the frm that emerges on the ex-dvdend day. Averagng across a large number of ndependent observatons on drop-off ratos s therefore requred to obtan a useful estmate of γ. Adjustments can also be made for market movements on ex-dvdend days (see below). For comparson wth Bell and Jenknson (2002), we follow the same approach as they n estmatng γ. Brefly, assume, followng Lakonshok and Vermaelen (1983), that the prce changes are random varables whch can be wrtten as P c - P ex = θd + ε (16) where the ε are ndependently dstrbuted wth 2 2 E(ε) = 0 and var ( ε ) P σ = ; (17) c that s the standard devaton of the unexplaned prce change s assumed to be proportonal to the share prce. As proposed by Boyd and Jagannathan (1994), an effcent estmate of γ, before and after the tax reform, can then be found by estmatng Pc P D D = θ + θ F + e (18) P P P ex 1 2 c c c where ε 2 e= and hence var ( e) = σ. (19) P c In (18), θ 1 provdes an estmate of γ pror to the tax reform. F s a dummy varable whch takes the value of 0 for observatons before the tax reform and 1 for observatons after the tax reform; hence θ 2 s an estmate of the change n γ followng the tax reform. Based on mcrostructure models developed by Boyd and Jagannathan (1994) and Frank and Jagannathan (1998), whch suggest a negatve ntercept n such a regresson, a constant term may also be ncluded. A further common adjustment s to account for market movements on the ex-dvdend day multpled by a hstorc estmate of the correlaton between the return on the share * m and the return on the market. That s, we replace P ex wth Pex = Pex Pc β R where R m s the return on the market on the ex-dvdend day, and β s the CAPM measure of rsk of that equty.

17 15 The second emprcal predcton concerns holdngs of U.K. equtes. Expresson (11) makes clear that, ceters parbus, any nvestor wll tend to hold more of a gven asset say when hs tax dscrmnaton varable for that asset ( γ ) s above the average of all nvestors ( γ ). As s clear from the dscusson above, untl 1997 the value of γ for U.K. penson funds holdng U.K. equtes was 1.25 and therefore sgnfcantly above the average value across all nvestors. owever, after 1997, ths value fell to 1. Ths mples that: Proposton 2 U.K. penson funds should hold a dsproportonately hgh share of U.K. equtes before 1997, but ths share should fall after By contrast, other nvestors should hold a dsproportonately low share of U.K. equtes before 1997, but should ncrease ther share after To nvestgate ths proposton, we report evdence on the composton of equty portfolos before and after 1997 for U.K. penson funds and other nsttutonal nvestors, and we report evdence on the share of U.K. equtes held by dfferent classes of nvestors. V. DATA We set up our data to mrror as closely as possble the data used by Bell and Jenknson (2002), henceforth BJ, to ensure that any dfferences we encounter are not caused by the samples. Specfcally, we use data from Thomson Fnancal Datastream on dvdend payments of quoted U.K. companes. Ths data set contans one observaton per payment,.e. typcally two observatons per frm per year, as most U.K. frms pay an nterm and a fnal dvdend n each accountng year. We merge daly data on share prces and return ndces nto ths data set, keepng n each case the observaton on the day when the share frst trades ex-dvdend and on the day before,.e. the ex-dvdend and cum-dvdend prces. Before runnng regressons, we clean the resultng data sets as follows. We drop any observatons where core data are mssng, such as the payment date, the ex-dvdend date, the (cum- or ex-dvdend) share prce or the value of the dvdend. We also drop observatons where the last cum-dvdend observaton predates the ex-dvdend observaton by more than 5 tradng days. We drop a few observatons for whch we cannot work out the accountng year end date, because we need ths n order to match the dvdend payment data wth nformaton from company accounts. After matchng the data wth company accounts, we drop all frms for whch the sum of ndvdual dvdend payments over the year does not match up wth the total dvdend payment reported n the accounts. Then we drop all dvdend payments that were desgnated as Foregn Income Dvdends, as the tax treatment for ths form of dvdends was dfferent. We also drop any observaton for whch the share prce dd not move on the ex-dvdend date, whch

18 16 suggests that there was no tradng. Fnally we drop outlers, whch we defne as drop-off ratos n excess of 5. As explaned above, we adjust returns for general market movements usng the CAPM. To allow comparsons wth BJ, we follow ther approach n estmatng the correlaton of each share s monthly returns wth market returns (β). We thus run separate regressons of each share s monthly return (ncludng captal gans and dvdends) on the monthly return of the FTSE All-Share ndex durng the 5 years precedng the tax reform. We only keep shares wth at least 36 hstorcal observatons. The cleanng procedure used by BJ s vrtually the same as ours, except that they dd not delete data where the sum of dvdend payments dffered from the fgure reported n company accounts, and they dd not drop outlers as defned above. ence our sample s slghtly smaller than thers, wth data on 7966 dvdend payments by 1275 frms. VI. RESULTS Ths secton frst presents emprcal evdence on the behavor of drop-off ratos n the U.K. It then brefly consders evdence on U.K. equty ownershp. BJ use the 1997 reform to test whether taxes affect the valuaton of dvdends and to attempt to fnd the dentty of what they refer to as "the" margnal shareholder. We frst replcate ther man fndngs usng our sample, confrmng that the mean drop-off rato dd fall sgnfcantly n the U.K. n the late 1990s. We then look n more detal at the nature and tmng of ths 17 change n the dstrbuton of drop-off ratos, and consder fluctuatons n the mean dropoff rato over a longer horzon. A. Bell and Jenknson (2002) Replcaton Table 1 presents the results obtaned from estmatng mean drop-off ratos for pre-reform and post-reform perods n a smlar way to BJ, based on OLS estmaton of equaton (18). Columns 1 and 2 reproduce the results from BJ; columns 3 and 4 present our replcatons. Lke BJ, we compare the 30 month perod before the 1997 tax reform wth the 30 month perod after the reform. Followng BJ, we report results for the sample of all frms and for the sub-sample of the largest 250 frms. Our results are very smlar to those obtaned by BJ. Whle we estmate a smaller fall than BJ, we confrm that there was a sgnfcant fall n the mean drop-off rato n the U.K. after July 1997, partcularly for larger frms. We mplemented a number of robustness checks, whch suggested that these results are robust. Specfcally, we consdered the followng alternatve specfcatons. (a) Includng a constant term to allow for certan ex-dvdend day tradng behavor as suggested by mcrostructure models n Boyd and Jagannathan (1994) and Frank and Jagannathan (1998): ths does not affect the estmated coeffcents. (b) Not correctng the ex-dvdend prce (P ex ) for market movements: ths hardly affects the coeffcents and leads to slghtly more sgnfcant falls n the mean drop-off ratos. (c) Not dealng wth heteroskedastcty,

19 17.e. just regressng the drop-off rato on a constant and a post reform dummy: ths does not affect the results for the sample of large frms. For the full sample, ths reduces the estmated fall n the mean drop-off rato by half. The estmated fall n ths case s only sgnfcant at the 13percent level. Before extendng the nvestgaton, t s worth dscussng the nterpretaton of these results. It s true that the estmated change n the mean drop-off rato, at least for the larger companes, s close to the theoretcal drop n the value of for U.K. penson funds: 20percent (BJ) or 17percent (our results) as aganst 20percent n theory. owever, f penson funds were "the" margnal shareholders, then the estmated levels of these mean drop-off ratos are not as expected. If penson funds were the margnal shareholders, the mean drop-off rato should be around 1.25 before the reform and 1 after the reform. 18 For the largest frms, the emprcal results suggest a mean drop-off rato of around 1 before the reform and around 0.8 after the reform. Of course, based on the asset prcng model set out n Secton III, we would not expect the mean drop-off rato to reflect only the tax rates of U.K. penson funds, but rather an average across all nvestors n U.K. equtes. Whle the levels of the mean drop-off ratos before and after the reform could reflect an average across nvestors, from ths perspectve, the sgnfcant fall n the mean drop-off rato s more surprsng. B. Drop-off Ratos and Dvdend Yelds BJ also consder changes n the mean drop-off rato for sub-samples dvded by dvdend yelds. The 1997 tax reform affected those shareholders wth the hghest valuaton of U.K. company dvdends. In the presence of clentele effects, hghly taxed nvestors would be expected to hold shares n low-dvdend-payng frms, and lghtly taxed (or subsdzed) nvestors would be expected to hold shares n hgh-dvdend-payng frms. Ths suggests that, before 1997, U.K. penson funds were more lkely to be the margnal shareholders for U.K. frms wth relatvely hgh dvdend yelds. If ths were the case, then the 1997 reform s expected to have most mpact on the mean drop-off rato for hgh-dvdend-payng frms. BJ report results that appear to support such clentele effects. Specfcally they use annual data on dvdend yelds to dvde ther observatons n the pre-reform and post-reform perods, separately, nto quntles. They then compare the mean drop-o rato for each quntle n the pre-reform perod wth the mean drop-o rato for the correspondng quntle n the post-reform perod. We replcate these results n Table Lke BJ, we fnd that the mean drop-off rato fell sgnfcantly only when comparng observatons wth relatvely hgh dvdend yelds, although t s not the case that observatons n the top quntle had the largest or most sgnfcant drop. 15 Unlke BJ, we present results based on ndvdual dvdend payments, rather than artfcal portfolos made up of all dvdend payments on the same day. BJ state that results were smlar n both cases.

20 18 Gven that the ratonale for splttng the sample by dvdend yelds s based on the tax preference of U.K. penson funds for a hgh dvdend yeld n the pre-reform perod, t would seem more approprate to dvde the full sample nto quntles based on dvdend yelds n the pre-reform perod only. We use data on average dvdend yelds n the prereform perod to dvde our sample of frms nto quntles. We then compare the mean drop-off rato for each quntle n the pre-reform perod wth the mean drop-o rato for the same sub-sample n the post-reform perod. Unlke the procedure used by BJ, ths ensures that we are comparng mean drop-off ratos for the same frms n the two subperods. Table 3 presents these results. When the samples are classfed n ths way, t s notable that the fall n the mean drop-off rato becomes small and statstcally nsgnfcant for the sub-sample wth the hghest dvdend yelds n the pre-reform perod. The clear pattern n the behavor of drop-off ratos by dvdend yelds reported by BJ s thus qute senstve to the precse way n whch ther sub-samples were chosen. Moreover, and regardless of the method used to select the sub-samples, we can note that the pattern of estmated mean drop-off ratos n the pre-reform perod provdes lttle support for the vew that the tax treatment of U.K. penson funds was partcularly mportant for the stock market valuaton of U.K. frms wth relatvely hgh dvdend yelds. 16 C. Evdence on the Dstrbuton of Drop-off Ratos To nvestgate the behavor of drop-off ratos further, we now consder the dstrbuton of drop-off ratos. The 1997 tax reform reduced the tax dscrmnaton parameter for the class of shareholders whch prevously had the hghest valuaton of dvdends. If U.K. penson funds were ndeed the margnal nvestors for certan types of U.K. frms, the fall n the mean drop-off rato reported n Table 1 should be assocated wth compresson n the upper part of the dstrbuton of drop-off ratos. Essentally, the hghest values of γ were elmnated by the tax reform, whle lower values of γ were unaffected. To examne ths predcton, Fgure 2 plots varous quantles of the dstrbuton of drop-off ratos over the same sample perod used n Table 1. In fact we see the opposte pattern, wth the fall n the mean drop-off rato after 1997 beng assocated wth a fall n drop-off ratos at the bottom end of the dstrbuton. The upper quartle ncreases from 1.3 n 1995 to 1.4 n 1999, wth no sgn of any reducton followng the 1997 tax reform. In contrast, the bottom decle falls steadly throughout ths perod, from 0.1 n 1995 to -0.6 n Ths ndcates that there was a consderable ncrease n the proporton of observatons wth negatve drop-off ratos. A negatve drop-off rato s found when the frm s share prce ncreases (relatve to the market) on the ex-dvdend day, notwthstandng the loss of the enttlement to the dvdend payment. We dscuss ths development further below, but note that shfts at the bottom end of the dstrbuton of drop-off ratos are not easly explaned by the change n the tax treatment of U.K. penson funds. More generally, 16 Consstent wth ths, we fnd that the smple correlaton coeffcent between the drop-off rato and the dvdend yeld n the pre-reform perod s less than 1 percent.

21 19 Fgure 3 shows that the dstrbuton of drop-off ratos wdened after 1997, whle dfferences n the tax treatment of dfferent classes of nvestors were reduced. Ths suggests that developments other than the 1997 tax reform may have been the domnant nfluence on the behavor of U.K. drop-off ratos durng ths perod. D. Further Evdence on Tmng We now extend the analyss to consder more carefully the tmng of these changes n the mean drop-off rato, and the longer term evdence. Followng BJ, our regresson analyss n Tables 1-3 neglected precse tmng ssues, as there was just one post-reform dummy: the test compared a 30 month perod before the reform wth a 30 month perod after the reform. In order to see more precsely when the fall n the mean drop-off rato occurred, we can estmate the mean drop-off rato for 6 and 12 month perods. To mantan comparablty wth the prevous results, we agan use the GLS estmaton procedure explaned n Secton IV. Table 4 presents these estmates of mean drop-off ratos for each year and half-year from 1995 to The annual estmates suggest that the mean drop-off rato dd not fall sgnfcantly untl 1999, although the tax reform was mplemented n July The sx monthly estmates suggest that there was a marked fall n the second half of owever they also show that there was a larger ncrease n the mean drop-off rato n the second half of 1998, whch stops ths showng up n the annual estmate for Indeed the mean drop-off rato n the second half of 1998 s the hghest found for any of these 21 sx-month perods. Ths ndcates that there are substantal fluctuatons n these estmates of mean drop-off ratos, whch may have more to do wth general stock market dynamcs rather than tax changes. To explore ths further, we consder longer term evdence. Fgure 2 plots annual and sxmonthly estmates of mean drop-off ratos between 1988 and Our orgnal sample perod s marked here by the two vertcal bars, wth the tax reform occurrng n the mddle of that perod. Ths evdence confrms that the behavor of the mean drop-off rato n the U.K. s ndeed erratc. There s a sharp ncrease from 1988 to 1991, whch s not explaned by any change n the tax treatment of U.K. penson funds. Both the fracton of equty owned by tax-exempt nsttutons (see below) and ther tax treatment were stable over ths perod. The tax dscrmnaton parameter for U.K. penson funds fell from 1.33 n 1992 to 1.25 n 1994, when the rate of the refundable dvdend tax credt was reduced from 25percent to 20percent. owever we see that there was no fall n the mean drop-off rato for U.K. companes over ths perod. The perod studed by BJ s thus unque n showng an assocaton between a sgnfcant fall n the mean drop-off rato and an ncrease n dvdend taxaton for U.K. penson funds. Furthermore, the mean drop-off rato at the end 17 Unfortunately we do not have the requred data on dvdend payments to calculate drop-off ratos before 1988.

22 20 of ths perod, n the second half of 2000, s very smlar to that at the start of the perod, n the frst half of 1988, although the relevant tax dscrmnaton parameter for U.K. penson funds had fallen from 1.33 to 1. These fluctuatons n the mean drop-off rato appear to be assocated wth changes at the bottom end of the dstrbuton, and n partcular wth the fracton of observatons where the drop-o rato s negatve. Table 5 reports annual fgures for the share of observatons wth negatve drop-off ratos. Ths fracton falls sharply from 1988 to 1991 and ncreases sharply towards the end of the 1990s, mrrorng the fluctuatons n the mean drop-off rato shown n Fgure 2. Negatve values for the drop-off rato observatons where the share prce ncreases despte the share gong ex-dvdend seem to be most common n perods when the stock market s both volatle and rsng. Ths was the case mmedately after the 1987 stock market crash, and agan durng the dot com bubble perod of the late 1990s. These developments n the tal of the dstrbuton of drop-off ratos appear to exert a strong nfluence on the behavor of the estmated mean. The behavor of the mean drop-off rato n the US provdes further grounds for doubtng whether the fall n the U.K. emphaszed by BJ was related to the 1997 U.K. dvdend tax reform. Estmates presented n Chetty, Rosenberg and Saez (2007) show that the mean drop-off rato n the US also fell sharply over the perod studed by BJ, from around 0.8 n 1994 to around 0.4 n 2000, wth the sharpest fall also occurrng from 1999 to Usng data over the perod , Chetty, Rosenberg and Saez show that such fluctuatons n the mean drop-off rato n the US are not uncommon, and dsplay lttle relatonshp wth changes n dvdend taxaton. Our evdence for the U.K. supports ther concluson: estmates of mean drop-off ratos are too volatle to provde relable evdence about the mpact of dvdend taxes on the stock market valuaton of frms. Equty ownershp The second proposton dscussed n Secton IV concerned the share of U.K. equtes n the portfolos of U.K. penson funds. Ths share s expected to fall after the July 1997 tax reform elmnated a major tax advantage for U.K. penson funds of dvdends from U.K. companes. Ths predcton also apples to the holdngs of U.K. nsurance companes nsofar as they relate to the provson of penson plans, although not to the provson of lfe nsurance. Table 6 reports the proporton of U.K. equtes n the total equty holdngs of U.K. penson funds, nsurance companes and unt trusts between 1990 and The U.K. share of penson fund equty portfolos dd ndeed fall sharply, from around three quarters at the end of 1996 to around two thrds by the end of 2001, havng been qute stable durng the frst half of the 1990s. The U.K. share of nsurance company equty portfolos also fell, from around 80percent to around 75percent, havng also been stable n the perod before ths tax reform. In contrast, for unt trusts mutual funds whose tax treatment dd not change at all n 1997 there was a temporary ncrease n the U.K. share of ther equty holdngs mmedately after the tax reform, although ths has snce returned