Ex-Dividend Day Stock Price Behavior: The Case of the 1986 Tax Reform Act*

This paper analyzes the behavior of stock prices around ex-dividend days after the implementation of the 1986 Tax Reform Act that dramatically reduced the difference between the tax treatment of realized long-term capital gains and dividend income in 1987 and completely eliminated the differential in 1988. We show that this tax change had no effect on the ex-dividend stock price behavior, which is consistent with the hypothesis that long-term individual investors have no significant effect on ex-day stock prices during this time period. The results indicate that the activity of short-term traders and corporate traders dominates the price determination on the ex day. THE 1986 TAX REFORM Act (TRA) was the most dramatic change in the U.S. tax code during the past 40 years. It eliminated the preferential tax treatment of long-term capital gains which was adopted in 1921. Dividend income and realized capital gain income are now treated equally for tax purposes. Using the change in the tax system, this study offers new evidence about the effect of taxes on ex-dividend day price behavior. It shows that this tax change had no effect on the ex-dividend stock price behavior. Our study also shows that the adverse tax treatment of individual investors' dividend income had less effect on prices in the 1980s than it had in the 1960s, even before the change in the tax code. In perfect capital markets, where investment policy is fixed, Miller and Modigliani (1961) showed that dividend policy does not affect the value of the firm. If dividends are taxed more heavily than capital gains, individual investors may require a higher pre-tax rate of return on dividend paying stocks. As Miller and Modigliani suggested, the uneven tax treatment of dividends and capital gains could lead to the formation of various 'clienteles' so that investors in high tax brackets hold low-yield stocks, while investors in low tax brackets will hold high-yield stocks. Elton and Gruber (1970) argued that taxing dividends more heavily than capital gains affects the behavior of *This paper won the 1989 Trefftzs Award of the Western Finance Association. ^Johnson Graduate School of Management, Cornell University. I would like to thank Yakov Amihud, Michael Brennan, Stephen Brown, Linda Canina, Bob Cumby, Ned Elton, Bill Greene, Marty Gruber, Joel Hasbrouk, Josef Lakonishok, Avner Kalay, Bob Litzenberger, Andy Lo, Ron Masulis, Sy Smidt, Marti Subrahmanyam, Bruce Tuckman, and Theo Vermaelen for helpful discussions and comments. The paper also benefited from comments of the seminar participants at NYU, the 1989 Western Finance Association, the 1989 European Finance Association, and the 1990 American Finance Association meetings.