The Effects of Taxes on Market Responses to Dividend Announcements and Payments: What Can We Learn from the 2003 Dividend Tax Cut?∗

This paper investigates the effects of capital gains and dividend taxes on excess returns around announcements of dividend increases and ex-dividend days for U.S. corporations. Consistent with standard no-arbitrage conditions, we find that the ex-dividend day premium increased from 2002 to 2004 when the dividend tax rate was cut. Consistent with the signalling theory of dividends, we also find that the excess return for dividend increase announcements went down from 2002 to 2004. However, these findings are very sensitive to the years chosen for the pre-reform control period. Semi-parametric graphical analysis using data since 1962 shows that the relationship between tax rates and ex-day and announcement day premia is very fragile and sensitive to sample period choices. Strong year-to-year fluctuations in the ex-day and announcement day premia greatly reduce statistical power, making it impossible to credibly detect responses even around large tax reforms. The important non-tax factors affecting these premia must therefore be understood before progress can be made in evaluating the role of taxation in market responses. ∗Raj Chetty, [email protected], Joe Rosenberg, [email protected], Emmanuel Saez, [email protected], University of California, Department of Economics, 549 Evans Hall #3880, Berkeley, CA 94720. We thank Alan Auerbach, Douglas Bernheim, Gustavo Grullon, Francisco Perez-Gonzalez, James Poterba, Douglas Skinner, and Joel Slemrod for helpful comments and discussions. Financial support from NSF Grant SES-0134946 and the Sloan Foundation is gratefully acknowledged.