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EX-DIVIDEND DAY VOLUME AND PRICE BEHAVIOR

177

THE IMPACT OF THE

1986 TAX REFORM ON

EX-DIVIDEND DAY

VOLUME AND PRICE

BEHAVIOR

CHUNCHI WU * & JUNMING HSU **

Abstract - This paper examines the

impact of the 1986 Tax Reform Act

(TRA) on trading volume and stock price

behavior around the ex-dividend day.

The paper shows that changes in capital

gain taxes exert a differential effect on

the trading volume and ex-day premi-

ums of stocks with different yields and

transaction costs. Results show that the

trading volume around the ex-dividend

day declines after the implementation

of the tax law. There is evidence that

short-term traders continue to focus on

high-yield stocks after the 1986 tax

reform and the magnitude of ex-

dividend day premiums is directly

related to their short-term trading

activity. Ex-dividend day premiums and

abnormal trading volume around the

ex-dividend day are significantly

affected by transaction costs, and these

effects appear to be stronger after 1986.

INTRODUCTION

In September 1986, the most sweeping

revision of the U.S. tax code in nearly

half a century became law. The new tax

law eliminated the preferential tax

treatment of long-term capital gains.

Under the old law, capital gains on

assets held at least six months were

taxed at only about 40 percent of the

rate applied to regular income. Begin-

ning in January 1987, the differential

taxation between dividends and capital

gains substantially narrowed.1 This

change represents the most significant

capital gains tax increase in recent years.

Whether this tax reform has influenced

stock price and trading volume is an

important issue, because it bears on

federal tax revenue consequences and

corporate financing strategies.

The objective of this paper is to examine

the impact of the 1986 Tax Reform Act

(TRA) on trading volume and stock price

behavior around the ex-dividend day.2

Capital gains and dividend taxes mayaffect market valuation of dividends and

corporate dividend policy. According to

the traditional view, if dividends are

taxed more heavily than capital gains,

*School of Management, Syracuse University, Syracuse, NY

13244-2130.**Department of Business Administration, Tunghai University,

Taichung, Taiwan.

National Tax JournalVol 49 no. 2 (June 1996) pp. 177-92


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NATIONAL TAX JOURNAL VOL. XLIX NO. 2

178

investors should demand a higher

before-tax premium from dividend

income. Investors can receive this

premium if the drop in stock price on

the ex-dividend day is less than the

amount of the dividend. However,

short-term traders could easily eliminate

this premium through dividend strip-

ping. The 1986 tax reform provides a

unique opportunity for examining the

effect of income tax rates on the ex-

dividend stock price and trading.

Similar to that of Michaely (1991), this

paper analyzes the behavior of ex-

dividend day premiums before and after

the implementation of the 1986 TRA.However, whereas Michaelys analysis

focused on stock price behavior, this

paper examines the impact of the 1986

TRA on trading volume around the ex-

dividend day and explores the linkage

between ex-dividend day price and

short-term traders behavior. Michaely

found that (1) the average premiums

were similar before and after the 1986

TRA and were indistinguishable from

one; (2) the tax reform did not change

the incentives of short-term traders and

had a very small impact on corporate

traders incentive to trade around theex-dividend day; and (3) the reduction in

transaction costs and structural changes

in the U.S. financial markets may have

resulted in the dominance of institu-

tional traders in the trading around ex-

day, and, consequently, a change in the

individual investors tax rates has no

significant effect on the ex-day prices.

Like Michaely, our paper finds that the

average ex-day premiums after 1986 are

generally similar to the average pre-

mium in 1986. Also, our results are

consistent with Michaelys conclusion

that transaction costs play an importantrole in the short-term trading after the

tax reform. However, in contrast to

Michaely, our results suggest that the

1986 TRA has significantly affected

short-term traders incentives to trade

around the ex-dividend day. It is found

that the trading volume around the ex-

dividend day declines after the imple-

mentation of the 1986 TRA. Further-

more, there is evidence that short-term

traders have continued to focus on

high-yield stocks since the 1986 tax

reform, and the magnitude of ex-

dividend day premiums is directly related

to their trading activity. However, short-

term trading activity and its influence on

the ex-dividend price apparently have

declined in the post-reform period.

Our results suggest that taxes of

dividends relative to capital gains haveimportant effects on valuation of

dividends and the trading activity

around the ex-dividend day. Our

findings thus support the old view of

dividend taxation, as in Poterba and

Summers (1983, 1984), suggesting that

taxes are important determinants of

dividend policy. Our results cast doubt

on the new view of Auerbach

(1979a, 1979b), Gordon and Bradford

(1980), and Bradford (1981), based on

the notion of tax capitalization, that

dividend decisions are unaffected by the

dividend and capital gain taxes.

Bernheim and Wantz (1995) find that

there is a strong positive relationship

between dividend tax rates and the

share price response per dollar of

dividends. Their result supports the

dividend signaling hypothesis that an

increase in dividend taxation should

increase the share price response to

dividend changes (or the dividend

signaling effect). Although we do not

directly address the issue of dividend

signaling, our findings suggest that the

1986 tax reform should decrease theshare price response per dollar of

dividends as a result of a reduction in

the relative tax burden of dividends

versus capital gains.



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1

2

1

2

The remainder of this paper is organized

as follows. The first section discusses

the major implications of the 1986 TRA

for ex-dividend price and volume

behavior. The second section describes

the data and the empirical methodol-

ogy. The third section reports the

empirical results. Finally, the last section

summarizes the main findings of this

paper.

THEORETICAL FRAMEWORK

Elton and Gruber (1970) examine the

issue of tax-induced dividend clienteles.

Under the assumptions that there are no

transaction costs and short-term traders,

no restrictions on short sales, and

investors are risk-neutral, they show that

the marginal tax rates of the marginal

investor can be inferred from the ex-

dividend day price drop relative to the

dividend amount. Their results imply

that the differential tax rates on

dividends and capital gains lead to a tax

clientele equilibrium.

Recently, Michaely and Vila (1995a)

suggested that, in the presence of a

perfect clientele, there should be notax-related gains from trade among the

investors around the ex-dividend day,

because investors are confronted with

the same relative after-tax valuation

of dividends and capital gains. In the

absence of disagreement on the relative

valuation, there should be no profit

opportunity and, consequently, no

abnormal volume around the ex-

dividend day. Thus, if a perfect clientele

exists, we should not observe a

significant change in trading volume

around the ex-day after the 1986 tax

reform.

The model suggested by Elton and

Gruber (1970) does not take risk into

account. In reality, trading around the

ex-dividend day is often subject to

substantial price risk for both individual

and institutional traders. This trading

risk is even more apparent for corporate

traders who are subject to the dividend

exclusion restriction. Heath and Jarrow

(1988) showed that there may be no

arbitrage opportunity on the ex-

dividend day, even if the ex-day pre-

mium is not equal to one, because of

the risk involved in the dividend-related

trading. Thus, the argument of short-

term arbitrage alone cannot explain the

price formation around the ex-dividend

day.

To account for the risk involved individend capture, Michaely and Vila

(1995a) proposed an equilibrium model

to explain trading volume and stock

price behavior around the ex-day. They

showed that the ex-day price drop

relative to the dividend amount is a

function of the average relative tax

rates of dividends versus capital gains

across traders and the total risk in the

economy. They also showed that the

trading volume around the ex-day is

positively related to the heterogeneity

of investors income taxes and the

dividend size and is negatively relatedto the variance of stock price.

The model developed by Michaely and

Vila (1995a) offers specific testable

implications for both ex-day premiums

and trading volume. Therefore, it is an

especially suitable framework for

empirical investigation of the stock price

behavior and trading volume around

the ex-day. According to Michaely and

Vila, the ex-day price drop can be

expressed as

PB

PA

= D e

X 2/ K

1

e



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equation 1 divided by the dividend

amount D:

E[(PB

PA

)/D] = X 2e/KD.

The first part of equation 4 is the

weighted average tax rate of dividends

relative to capital gains, where the

weight is inversely proportional to

each agents risk aversion. Taxes thus

affect the ex-day premium, and the less

risk-averse agents have more weight

in affecting this premium. The second

part is the premium for the risk involvedin the ex-day trading. Note that the

expected ex-day premium will not be

equal to one, even if is equal to one,

because 2e

is positive. The higher the

risk involved in dividend-related trad-

ing, the lower the expected ex-day

premium.

Michaely and Vila (1995a) also showed

that the trading volume around the ex-

dividend day is

The trading volume is positively related

to the difference between an agents tax

rate of dividends relative to capital gains

i and the weighted mean . That is,

the more heterogeneous the tax

structure is, the higher the trading

volume around the ex-dividend day. Also,

as shown in equation 5, volume contains

additional information about investorstax preferences.

Based on the above equilibrium relation-

ships, we can establish several empirical

where

PB= the price per share cum-dividend,

PA = the price per share ex-dividend,

= the average preference for

dividend income relative to capital

gains weighted by tax-adjusted

risk tolerance

D = the dividend per share announced

by the firm

= the ex-day stock price disturbance

X= the aggregate demand for the

stock on the ex-day

= the ex-day variance of stock price

and

K= the aggregate risk tolerance in the

economy.

In notations,

and

where Ki= 1/[ i(1 ig)], i = (1 i

d)/(1

ig), i is the constant risk aversion

coefficient, and id

and ig

are the

dividend and capital gain tax rates for

investor i. By construction, Ki is the tax-

adjusted risk tolerance, and is the

average of Nagents tax rates of

dividend income relative to capital gains,

i, weighted by their tax-adjusted risktolerance.

2e

2

KiK=

N

i=1

3

4

5

NN

i=1

N

=i=1

Ki i/ Ki

e

The expected ex-day premium can be

derived by taking the expectation of

}Ve = D ( i ) Ki/2e{12 i=1 .



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reform, there were fewer tax brackets

(rates); i.e., there were 11 tax brackets

before the tax reform and only 4 after.

The reduction in the number of tax

brackets and rates decreases the tax

heterogeneity. According to equation 5,

the more homogeneous the tax

structure is, the lower the trading

volume around the ex-dividend day. In

the extreme case with only one tax

bracket, all investors agree upon what

should be the consequences of dividend

distribution. In the lack of disagreement

on the relative value of dividend income

versus capital gains, no dividend-related

trading will occur. Conversely, when the

tax structure is more heterogeneous,there will be greater disagreement on

the relative value of dividends, which

creates more profitable opportunities for

trading and, consequently, higher

trading volume. The above argument

leads to the following hypothesis.4

HYPOTHESIS 2: The 1986 TRA will have

a negative impact on the abnormal

trading volume around the ex-dividend day.

The new tax law also reduced the

maximum income tax rate of corpora-

tions from 46 to 40 percent in 1987 andto 34 percent in 1988. At the same

time, the dividend tax exemption rate

dropped from 85 percent in 1986 to 70

percent in 1988. The maximum dividend

tax rate of taxable corporations thus

rose from 6.9 to 10.2 percent, approxi-

mately a 47 percent increase. This

increase in the effective dividend tax

rate should reduce the incentive for

dividend stripping. Previous studies

(Lakonishok and Vermaelen, 1986;

Karpoff and Walkling, 1990) have

indicated that stocks with high dividend

yields are the main targets of incorpo-rated traders. The new tax law makes

incorporated traders dividend capture

less profitable and, therefore, discour-

ages their trading around the ex-

hypotheses with respect to ex-day

premiums and trading volume before

and after the 1986 tax reform. The

1986 TRA increases the capital gain tax

rate. This increase in the capital gain tax

directly affects the magnitude of the

expected equilibrium ex-day premium in

equation 4. The capital gain tax rate ig

affects the average preference for

dividend income versus capital gains,,

the aggregate risk tolerance, K, and the

aggregate demand for the stock,X, on

the ex-dividend day. Since the effects of

g

on KandXare of the same magni-

tude (see Michaely and Vila, 1995a), the

net effect of the increase in the capital

gain tax on the ex-day premium mainlydepends on its impact on . It can be

shown that /g

is positive. The new

tax law increases each individuals

capital gain tax rate ig

and the tax-

induced preference for dividend income

versus capital gains i, which is equal to

(1 id)/(1 i

g). Since is a weighted

average of i, an increase in i for each

individual leads to an increase in .

Other things being equal, the expected

ex-day premiums in equation 4 should

increase after the elimination of the

preferential tax treatment of capital

gains. This argument leads to our firsthypothesis.

HYPOTHESIS 1: The average (expected)

ex-day premium (PB P

A)/D will be larger

in the post-reform period than in the

pre-reform period.

Similar to Michaely (1991), the hypoth-

esis above holds only in expectations.3

The effect of the capital gain tax

increase will be smaller if trading for

stocks is dominated by short-term

traders or by more risk-averse agents.

The equilibrium relationship in equation

5 provides important empirical impli ca-

tions for the trading volume around the

ex-dividend day. After the 1986 tax



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dividend day. This reduction in trading

volume can also be explained using

equation 5. Let cand L be the tax

rates of dividends relative to capital

gains for incorporated traders and long-

term individual investors, respectively.

The 1986 TRA increases the effective

dividend tax rate for incorporated

traders and decreases c. The mean

also decreases but does not fall as much

as c, since the weight of incorporated

traders is less than one and L increases

after the 1986 TRA. The increase in L

will be small if high-yield stocks are held

by investors with low income tax rates.

The term c (>0) decreases and the

trading volume drops, which generallydepends on the proportion of trading by

corporations. Since trading of high-

dividend yield stocks is dominated by

incorporated traders, the volume for

high-dividend yield stocks is likely to

drop more around the ex-dividend day.5

The following hypothesis summarizes

this argument.

HYPOTHESIS 3: The 1986 TRA will have

a more negative impact on the trading

volume of high-dividend yield stocks

around the ex-dividend day.

Another important factor affecting a

traders short-term trading is transaction

costs. Michaely and Vila (1994) showed

that trading volume is lowered by the

presence of transaction costs. Higher

transaction costs not only reduce an

investors net returns but also make tax

arbitrage riskier. Transaction costs differ

among stocks. In general, the new

tax law discourages short-term trading

of stocks with higher transaction costs

more than that of stocks with lower

transaction costs. The new tax law

increases the effective tax rate ofdividends earned by incorporated

traders and therefore, reduces the net

profits of dividend capture and makes

trading of stocks with higher trans-

action costs unprofitable. Also, the

exday premium will be smaller for

stocks with higher transaction costs

because dividend capture trading for

these stocks is discouraged by the new

tax law. The ex-day premium will

decrease as the dividend capture activity

decreases (see also Michaely and Vila,

1995a). Thus, the ex-day premiums

will appear to be negatively associated

with the transaction costs of trading.

We summarize this argument below.

HYPOTHESIS 4: In the post-reform

period, short-term trading volume

around the ex-day will be lower and

the ex-day premium will be smaller forstocks with higher transaction costs.

Transaction costs are usually negatively

related to stock price and firm size

(Karpoff and Walkling, 1990).

Therefore, we should observe a positive

relation between ex-day premiums and

firm size or stock price. This positive

relation is expected to be stronger in

the post-reform period. Given a higher

effective tax rate and lower profits for

dividend capture, short-term trading

tends to be more sensitive to trans-

action costs. In the following section,we discuss the data and the empirical

methodology.

DATA AND EMPIRICAL METHODOLOGY

Data were obtained from the Center for

Research in Security Prices (CRSP) Daily

NYSE/AMEX File. The data contain

regular cash dividend distributions, daily

price, and firm capitalization for the

period from September 1984

December 1990. Daily trading volume

for the entire year is available on the

1991 CRSP tape starting in 1986. Thesample includes a total of 1,241

companies and 1,599 trading days. The

1984 data were mainly used to compute

the residual variance of the market



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model for firms with ex-dividend days

in the early part of the first quarter in

1985. The data sample excludes

exchange offers, tender offers, stock

splits, liquidating dividends, subscription

rights, and new share offerings. In

addition, the following rules were adopted

for further data screening. First, divi-

dends paid by foreign currency were

excluded. Second, to avoid distortions

due to dividend announcements, all

observations from which the announce-

ment and ex-dividend dates were six or

fewer trading days apart were dropped

from the sample. Third, cash dividends

lower than $0.125 were omitted to reduce

biases caused by the minimum allow-able price fluctuation. The final sample

includes 2,246 events in 1985, 1,817

events in 1986, 1,787 events in 1987,

2,281 events in 1988, 2,213 events in

1989, and 747 events in 1990. To avoid

a potential bias induced by high price

volatility of the October 1987 crash, the

1987 data contain only the records for

the first nine months. For the purpose of

comparability, we compute statistics using

the first nine months of 1986. We also

compute the results for the entire years

of 1986 and 1987 and report them

when they are materially different fromthe nine-month results. The empirical

investigation involves estimation of both

abnormal trading activity and premiums

around the ex-dividend day. We discuss

next the estimation and test procedures

for abnormal volume and ex-dividend

day premiums.

To estimate abnormal transaction

volume, we first calculate normal dollar

trading volume based on the daily

trading volume over a period of 45 to

25 days before the ex-dividend date.

The selection of this estimation periodavoids the potential problem of overlap-

ping with the ex-dividend period of the

previous quarterly dividend and the

dividend announcement date.6

For each ex-dividend event, daily

abnormal trading volume in both dollar

and percentage terms is calculated for

an 11-day period beginning five days

before the ex-dividend date and ending

five days after the ex-dividend date. The

abnormal volume is taken from the

difference between the actual and

normal trading volumes. Then, the

average daily abnormal trading volume

in both dollars and percentage is

obtained based on all ex-dividend cases

for the period of five days before the ex-

dividend date to five days after.

The t-statistics for average abnormal

volume are computed as follows:

whereAVt,i

is the abnormal volume on

day tfor each event case i= 1, . . ., N

and (AV) is the standard deviation of

the abnormal volume on day t.7 All t-

statistics are calculated based on the

event time method.

To estimate the premium around the ex-

dividend day, we estimate a weighted

mean premium using a generalized

least-squares method suggested by

Michaely (1991):

where

pi= the difference between the cum-

dividend price (PB,i

) and ex-dividend price

t =N/

i=1

N

AVt,i(AV)

6

7

i=1

p =

N

i=1

N

(d2i/

2i)pi

(d2i/

2i )



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(PA,i

) divided by dividend per share (Di),

di= the dividend per share divided by

the cum-dividend price per share,

2i = the residual variance obtained

from the ordinary least-squares

regression of the market model,

and

i= 1, 2, . . ., Nis the subscript

representing each ex-dividend

event case.

The above formula corrects two sources

of heteroskedasticity: the securitys own

conditional variance 2i and the dividendyield (d

i) effect. Following Michaely

(1991), we estimate the market model

by least squares using return data in

days 25 to 2 and +2 to +25, where

day zero is the ex-dividend date.The

residuals obtained from the regression

are used to estimate the variance term.

EMPIRICAL RESULTS

Table 1A reports the average premiums

by years before and after the tax reform.

Mean ex-dividend day premiums for the

years 198688 and 1990 are all close to

one. TheZ-statistics show that the

average premiums for these years are

not significantly different from one.

However, the mean ex-day premiums

are significantly different from one for

1984, 1985, and 1989. The results for

1984 and 1985 are consistent with

Grammatikoss (1989) findings that ex-

day premiums are less than one for the

period 197585.8

The last column in Table 1A shows the

results of the Fisher sign test, whereascolumn 5 reports the percentage of ex-

day premiums that are greater than one.

The results show that the number of ex-

day premiums below one is not statisti-

cally different from the number of

premiums above one only for the years

1987 and 1990. For the remaining

years, the number of premiums below

one is significantly higher than the

number of premiums above one.

In Table 1B, we report average ex-

dividend day premiums by removing the

restriction that cash dividends have to

be larger than $0.125.9 The results are

now closer to those reported by

Michaely (1991). All ex-day premiums in

the post-reform period and in 1986 are

now insignificantly different from one.

Also, consistent with Michaely, the

Fisher sign test shows that the numberof ex-day premiums below one is not

statistically different from that above

one for 1986.10 Therefore, the differ-

ence between our results in Table 1A

and Michaelys results is mainly attrib-

uted to the restriction on the magnitude

of cash dividends in our sample.

However, the Fisher sign test still

indicates that the number of ex-

dividend day premiums below one is

greater than the number of premiums

above one for the years 1985, 1988,

and 1989.

A comparison of the ex-day premiums in

the pre- and post-reform periods shows

some variations. In Table 1A, the ex-day

premium in 1986 is not significantly

lower (at the five percent level) than

that in any of the years from 198790.

A similar pattern is also found in Table

1B. Based on the results for the year

1986 and after, we could not support

Hypothesis 1 that the 1986 TRA

increased the ex-day premium. However,

the results show that the ex-day

premium significantly increased after

1985.

The 1986 TRA reduced the heterogene-

ity of the tax structure. The theory

predicts that the abnormal trading



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volume on the ex-dividend day should

decline as a result of the tax law

change. Table 2 shows the averagecumulative abnormal trading volume

(from t= 3 to 0) for the years before

and after the tax reform. Note that

complete daily trading volume records

for the entire year were available on the

1991 CRSP tape starting in 1986.

Comparing the trading activity of 1986

with those of the remaining years, the

abnormal volume (in thousands) around

the ex-dividend day generally declined

after the tax reform. For instance, the

cumulative abnormal trading volume

declined from 12,521 in 1986 to 6,718

in 1990, in dollar terms (thousands),and from 43.90 in 1986 to 23.85 in

1990, in percentage terms. The last

column of Table 2 reports the average

abnormal volume over the period 1987

90. The cumulative abnormal volume

dropped to 9,578 in dollar terms and

33.57 in percentage terms during thisperiod. These results support Hypothesis

2 that the 1986 TRA adversely affected

the abnormal trading volume before

the ex-dividend day.11

The abnormal trading around the ex-

dividend day began to have a larger

decline in 1988. The relatively large

volume in 1987 may be due to trading

by Japanese life insurance companies.

These companies are known to have

been very active around the ex-dividend

day in 1987 (Koski, 1993). Also,

although the 1986 TRA increased theeffective dividend tax rate for taxable

corporations, the dividend exemption

rate did not drop to 70 percent until

1988. In 1987, the rate was 80 percent

TABLE IAEX-DAY PREMIUMS BEFORE AND AFTER THE 1986 TAX REFORM

(DIVIDEND PER SHARE > 0.125)

Standard Percentage FisherDeviation >1.0 Z-Value

1984 0.892 1.072 45.05 1.9391985 0.871 1.192 5.101 43.09 6.5411986 1.061 2.122 1.020 47.08 2.0801987 1.083 1.925 1.828 49.13 0.7331988 0.972 1.230 45.281989 0.909 1.332 42.971990 1.059 1.321 48.59

Note: Cash dividends lower than $0.125 are excluded in the calculation o f ex-day premiums.

1.960

1.0793.1951.237

4.5016.6110.768

Year Mean Z-Value

TABLE IBEX-DIVIDEND PREMIUMS BEFORE AND AFTER THE 1986 TAX REFORM

Standard Percentage FisherDeviation >1.0 Z-Value

1984 0.896 3.902 0.623 47.17 1.3231985 0.865 2.146 3.507 44.52 6.1751986 1.040 2.735 0.832 48.16 1.5081987 1.051 2.773 0.925 49.81 0.1841988 0.968 2.094 0.873 45.63 4.7721989 0.924 2.640 1.632 44.14 6.2341990 1.048 1.845 0.837 47.50 1.516

Note: Cash dividends lower than $0.125 are included in the calculation of ex-day premiums.

Year Mean Z-Value



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and the exemption rate increased if the

corporate ownership was 20 percent or

more. Thus, the full effect of the tax

increase on short-term trading was

more likely to take place since 1988.

As indicated earlier, the 1986 TRA may

have a greater impact on the trading

volume of high-yield stocks. To evaluate

the impact of the tax reform on the

volume of stocks with different dividend

yields, the sample is divided into ten

dividend yield deciles for each year.

Table 3 reports the mean ex-day

premiums and abnormal volume for

each dividend yield group for the

periods before and after the tax reform.

As shown in the table, short-term

trading centers on high-yield stocks. Asin Lakonishok and Vermaelen (1986),

the abnormal volume reported in Table

3 is the average daily abnormal volume

using data for days 3 to 1. Average

abnormal volume is generally very high

for the three highest dividend yield

deciles.

Average ex-dividend day premiums in

Table 3 generally increase with dividend

yields. Average premiums are much

larger for the highest three dividend

yield deciles, especially for the period

198790. While average ex-daypremiums are often significantly larger

than one for the high-yield deciles, the

average premiums for low-and-middle

yield deciles are frequently significantly

smaller than one. As suggested by

Michaely and Vila (1995a), the ex-day

premiums can be less than one because

of the risk involved in the dividend-

related trading. The ex-day premiums

can also be less than one, because theeffective capital gain tax rate may

still be less than the ordinary income

tax rate. An individual may defer

realization of accrued capital gains to

reduce the effect of tax rate on such

gains. This lock in effect implies that

the real capital gain rate may be less

than the ordinary income tax rate.

The abnormal dollar volume for stocks

in deciles 8 and 10 declines after

1986.12 The abnormal volume declines

even more sharply after 1988. These

results support Hypothesis 3 thatpredicts a negative impact of the 1986

TRA on the abnormal trading volume

of high-yield stocks. This negative

impact on volume is much greater after

1988.

The short-term trading volume is

negatively related to transaction costs.

Since transaction costs are negatively

correlated with firm size (see Lakonishok

and Vermaelen, 1986), firm size can be

used as a proxy for the transaction cost

variable. To examine the effect of

transaction costs, we divide the sampleinto different size groups. We first rank

stocks according to the dividend yield

and then the market capitalization of

the firm.13 Four dividend yield groups

TABLE 2CUMULATIVE ABNORMAL TRADING VOLUME AROUND THE EX-DIVIDEND DAY

Years

1986 1987 1988 1989 1990 198790

12,521 14,395 8,930 7,356 6,718 9,578(14.89) (19.39) (15.14) (13.91) (9.41) (29.42)43.90% 44.01% 35.75% 25.48% 23.85% 33.57%

Note: Reported are cumulative abnormal dollar volume (in thousands) from t= 3 to 0, t-statistics (in parentheses),and abnormal percentage volume.



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187

are formed, and, within each dividend

yield group, four subgroups are formed

according to the market capitalization. In

total, the sample is divided into 16 groups.

Because the number of observations in1984 is not sufficiently large, we focus

on the period 198590 in this analysis.

Table 4 presents the average ex-dividend

day premiums and abnormal volume by

dividend yields and firm size. As

indicated, the abnormal trading volume

increases with dividend yields and firm

size. These results are generally consis-

tent with Lakonishok and Vermaelens

(1986) findings. Within each dividend

yield group, abnormal trading volume is

positively correlated with firm size. A

comparison of the results for the pre-and post-reform periods indicates that

the 1986 TRA tends to have a more

negative impact on the trading volume

of high-yield stocks of smaller firms.

To examine the effects of the tax

reform, we regress ex-day premiums

against dividend yields and the transac-

tion cost variables for the periods before

and after the tax reform. Table 5Areports the results.14 In the first regres-

sion, we incorporate dividend yield and

the inverse of stock price as explanatory

variables. Following Karpoff and

Walkling (1988), we use stock price

inverse here as a proxy for the transac-

tion cost variable. The results show that

the coefficients of dividend yields are

significantly positive in both subperiods

198486 and 198790. The coefficient

of the price inverse is negative and

significant (at the one percent level) only

in the post-reform period. The higher

the stock price inverse is, the higher thetransaction cost. The results show that

higher ex-day premiums are associated

with lower transaction cost stocks. The

results also show that the marginal

TABLE 3AVERAGE EX-DAY PREMIUMS AND ABNORMAL VOLUME BY YIELD DECILES

Decile

0.4890.6310.7270.8300.9281.0471.2071.4621.833

11.421

0.9180.5600.6220.7490.6580.6730.6620.8470.9361.141

2.091.411.191.451.960.742.880.610.752.61

6114767

1,1992,159

7373,1449,4625,046

16,141

0.872.19

1.0618.5924.18

9.9444.79

142.4793.82

281.60

198486

Abnormal Volume (%)Abnormal Volume ($)z-ValueMeanYield (%)

123456789

10

12345

6789

10

0.4620.5830.6850.7820.896

1.0491.3361.6981.9976.422

0.7090.5800.6900.6760.609

0.7200.8361.0721.1021.057

1.312.922.245.014.01

3.123.742.462.582.36

4101,0671,4961,3632,080

2,2402,3766,1316,1009,370

1.112.696.434.383.93

4.503.26

31.72108.44196.21

198790

Notes: Average ex-day premiums and abnormal trading volume are reported for ten dividend deciles for theperiods 198486 and 198790, respectively. Column 2 reports the cutoff points for the dividend yield groups. Theabnormal volume is the average daily excess volume from t 3 to t 1.



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188

effect of transaction costs on ex-day

premiums in the post-reform period is

greater than that in the pre-reform

period (5.919 versus 1.139).15 In the

second regression, we replace stock

price inverse with firm size (market

capitalization) as a proxy for thetransaction cost variable. The results are

similar to the first regression except that

the firm size variable has a less signifi-

cant effect on ex-dividend day premi-

ums. The coefficient of firm size is

positive and significant at the ten

percent level in the post-reform period.

Consistent with the finding of Eades,

Hess, and Kim (1994), our results show

that dividend yields and transaction

costs affect the ex-day premium. Inaddition, we find that transaction

costs have a larger effect on the ex-

day premium in the post-reform

period.16

12

TABLE 4AVERAGE EX-DAY PREMIUMS AND ABNORMAL VOLUME BY YIELDS AND FIRM SIZE

Yield Group

1234

1234

1234

12

34

0.8720.4050.6170.508

0.5870.6530.6970.684

0.6010.6530.7550.867

1.0141.029

1.2271.047

0.902.132.412.25

2.522.532.592.74

3.704.392.931.46

0.170.40

3.840.41

18.839.219.34

0.76

11.0217.2845.6814.78

20.1526.3347.3549.67

253.48251.01

363.50127.88

176232523

141

55320

2,7983,138

3101,5744,966

22,283

7583,541

16,30320,964

198586

Abnormal Volume (%)Abnormal Volume ($)z-ValueMeanSize Group

1111

2222

3333

44

44

0.3250.4930.5420.769

0.4440.5290.6870.866

0.8700.8150.7680.974

0.9591.0511.1291.172

2.622.242.151.22

3.783.463.371.29

1.452.283.160.38

0.750.692.663.39

133465846

1,878

34700

2,0394,274

81542

2,2069,173

2583110,76618,689

2.884.102.502.16

1.126.907.254.59

3.716.269.388.04

6.5342.30136.68

50.75

198790

Notes: Firm size is measured by the market capitalization of the firm. The abnormal volume is the average dailyexcess volume from t 3 to t 1. Reported are average figures for the periods 198586 and 198790,respectively.

1111

2222

3333

4444

1234

1234

1234

1234



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189

Table 5B reports the results of regressing

abnormal volume against dividend

yields and the transaction cost variable.

As shown in the table, the coefficients

of these two variables are highlysignificant and of the correct sign.

Similar to Michaely and Vila (1994), the

abnormal trading volume is positively

related to dividend yield and negatively

related to transaction costs. However,

we find that the negative effect of

transaction costs on abnormal trading

volume is much larger in the post-

reform period.

The difference between the coefficients

of the transaction cost variable (price

inverse) in the two periods is significant

(t= 3.099). The results are consistentwith the contention in Hypothesis 4 that

the new tax law induced a more

negative impact on short-term trading

of stocks with higher transaction costs.

Summary and Conclusions

This paper examines the impact of the1986 tax reform on the trading volume

and stock price behavior around the ex-

dividend day. The paper finds that the

trading volume around the ex-dividend

day declined after the implementation

of the 1986 TRA. Thus, the change in

the tax structure appears to affect

adversely the incentives of short-term

traders to trade around the ex-dividend

day. Also, there is evidence that short-

term traders have continued to focus on

high-yield stocks since the 1986 tax

reform, and the magnitude of ex-

dividend day premiums is directly relatedto their short-term trading activity.

However, short-term trading activity and

its influence on the ex-dividend price

apparently have declined in the post-

reform period. Furthermore, the paper

finds that abnormal trading volume

around the ex-dividend day is signifi-

cantly affected by transaction costs of

dividend stripping, and these effects

appear to have become much stronger

since 1986.

Our findings suggest the importance of

taxes in corporate dividend decisions.Both ordinary and incorporated inves-

tors seem to recognize that taxes affect

their investment returns. If taxes are not

relevant, then the 1986 TRA should not

3

TABLE 5ACROSS-SECTIONAL REGRESSION RESULTS: EX-DAY PREMIUMS AS THE DEPENDENT VARIABLE

Year

198486 0.465(5.195)

0.434(6.025)

27.171(4.347)

26.145(4.431)

1.139(0.475)

0.003(0.406)

0.633(8.951)

0.488(7.734)

32.127(5.971)

24.761(5.356)

5.919(2.901)

0.010(1.814)

Note: t-statistics are reported in parentheses.

Size1/PriceDividend YieldConstant

198790

TABLE 5BCROSS-SECTIONAL REGRESSION RESULTS:

ABNORMAL VOLUME ($) AS THEDEPENDENT VARIABLE

Year

1986

198790

Note: t-statistics are reported in parentheses.

1.301(1.420)

0.250(0.210)

907.868(13.075)

1,676.921(18.534)

204.319(7.035)

343.658(10.016)

ConstantDividend

Yield 1/Price



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190

affect the short-term trading activity

around the ex-day. The short-term

trading volume around the ex-day

reflects investors tax preferences. The

differences in investors income tax rates

result in a disagreement on the relative

value of dividends, which creates

profitable opportunities for trading and,

consequently, higher volume around the

ex-day. The 1986 TRA reduces the

number of tax brackets and the hetero-

geneity of tax structure. The empirical

results are consistent with the conten-

tion that this decrease in the tax

heterogeneity results in less disagreement

on the relative value of dividends versus

capital gains and, hence, lowers the short-term trading volume around the ex-day.

Our results therefore support the old

view (Poterba and Summers, 1983,

1984) that taxes affect the relative

valuation of dividends and corporate

dividend policy. Our results cast doubt

on the new view (Auerbach, 1979a,

1979b; Bradford, 1981) that dividends

are unaffected by dividend and capital

gain taxes. The new view is based on

the notion that the stock market

capitalizes tax payments associated with

dividends and that this capitalizationleaves investors indifferent between

dividends and capital gains. Recently,

Bernheim and Wantz (1995) found that

there is a strong positive relationship

between dividend tax rates and the

dividend signaling effect. Our results

imply that the 1986 TRA should

decrease the dividend signaling effect,

measured by the share price response

per dollar of dividends, because the

relative cost of dividends versus capital

gains is reduced. Our findings also

suggest that any studies addressing the

issue of the effectiveness of dividendsignaling (e.g., Kao and Wu, 1994a,

1994b) should explicitly account for the

tax effect to better explain corporate

dividend behavior.

ENDNOTES

This study was funded by the George E. Bennett

Center for Tax Research, School of Management,Syracuse University. We are grateful to Maurice

Harris, William Lane, and especially to the Editor,

Joel Slemrod, and two anonymous referees for

extremely helpful comments. An earlier version of

this paper was presented at the 1992 Financial

Management Association meetings.

1 Although the preferential tax treatment of capital

gains was greatly reduced, there has been a

maximum tax rate on capital gains. For instance, in

1987, the maximum tax rate on capital gains was

28 percent while it was 33 percent for dividend

income.2 Since the enactment of the Tax Reform Act of

1986, many studies have focused on its impact on

securities trading (see Henderson, 1990; Badrinath

and Lewellen, 1991; Bolster, Lindsey, and Matrusi,

1989), ex-dividend day premiums (Michaely, 1991;Michaely and Vila, 1995a), real estate investments

(Copley and Garris, 1989), tax revenue and

effective capital gain tax rates (Poterba, 1987;

Coyne, Fabozzi, and Yaari, 1989), and other

related issues.3 We thank a referee for pointing this out.4 See also proposition 1 in Michaely and Vila (1995b)

for a similar argument.5 This result can be explained by a numerical

example. Let the weights of the agents be i= Ki/K, i= c, L, and a, for incorporated traders, long-

term investors, and short-term arbitragers,

respectively. Let, c+ L + a = 1, = cc+ LL +aa, and M= cc + LL + aa . The trading volume (in percentage) can beexpressed as V

e/X= 1/2 (MKD/X 2

e) = 1/2 M(D/P)/

, where =X

2

e /KP

. Following Michaely and Vila(1995a), we set the dividend yield (D/P) equal to

one percent and the risk premium = 0.0102, andassume that long-term investors have a marginal

tax rate of 50 percent on dividend income and 20

percent on capital gains. Also, let c = 50 percent,L = 30 percent, and a = 20 percent. Thecorporate tax rates are as indicated in text. Then,

before the enactment of the 1986 TRA, c=1.724, L = 0.625, a = 1, = 1.25 and V

e/X= 23

percent. After the tax reform, c = 1.360, L = 1,a = 1, = 1.18, and V

e/X= 9 percent. Thus, the

abnormal volume drops. In general, we can show

that, after the tax reform, M= 2(1 c)c(c L),since L = a. For c 0.5, the higher c is, thelower Mand V

e/X.

6 Lakonishok and Vermaelen (1986) use the period

from 65 to 25 days before the ex-dividenddate for estimation of the normal volume.

Grammatikos (1989) has indicated that their

estimation period could overlap with the

ex-dividend day of the previous quarterly divi-

dend.



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191

7 The t-statistic for average abnormal volume could

be drawn from a nonstandard distribution, which

is skewed or leptokurtic.8

The average (raw) ex-day premiums reported byGrammatikos (1989) are 0.877 and 0.796 for the

periods before and after the 1986 tax reform,

respectively.9 Michaely (1991) does not impose the minimum

cash dividend restriction. We impose this restriction

to reduce the potential bias fo r the measures of ex-

day premiums of very low dividend paying stocks

due to the minimum price fluctuation set at $1/8.10 Michaely (1991) reports the results of the Fisher

sign test for the years of 196667, 1986, and

1987.11 We also examined the abnormal turnover, which is

the abnormal dollar volume relative to the

outstanding share value. The results for this

alternative measure are not materially different

from our reports.12

Similar results also occur for the shorter period. Forexample, the differences between the level of

abnormal volume in 1986 and 1987 are s ignificant

with t-test statistics equal to 4.670 and 13.317, for

deciles 8 and 10, respectively. The annual results

are available upon request.13 Our grouping is different from that of Lakonishok

and Vermaelen (1986). They used average daily

trading volume as a proxy for firm size, while we

employed market capitalization reported in the

CRSP tape as the proxy.14 The regression includes dividend yield and stock

price inverse, which may not be independent of

the past values of the disturbance term. This might

cause a stochastic regressor bias.15 However, the difference is insignificant due to high

standard errors.16

The study by Eades, Hess, and Kim (1994) assigns adummy variable with a value of one for the period

between January 1987October 1989, in the

return regression, to examine the effect of the

1986 tax reform. The coefficient of this dummy

variable is not significant, which suggests that the

1986 tax law change does not significantly affect

the ex-day return.

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