New evidence of the impact of dividend taxation and on the identity of the marginal investor

This paper examines the impact of a major change in dividend taxation introduced in the United Kingdom in July 1997. The reform was structured in such a way that the immediate impact fell almost entirely on the largest investor class in the United Kingdom, namely pension funds. We find significant changes in the valuation of dividend income after the reform, in particular for high-yielding companies. These results provide strong support for the hypothesis that taxation affects the valuation of companies, and that pension funds were the effective marginal investors for high-yielding companies. IT IS VERY RARE FOR GOVERNMENTS to design their tax changes in a way that allows clean tests of important hypotheses. However, in July 1997, the incoming Labour government in the United Kingdom radically reformed the taxation of dividend income in such a way that the immediate impact fell almost entirely upon one important class of investors, namely pension funds. As is well known, pension funds are the single biggest class of investors in U.K. equities. It was estimated, in 1997, that over one third of U.K. equities were held by pension funds, and the impact of the tax change was to increase the taxation of dividend income by £5bn ~$7.5 bn! per annum. We use this major tax change to examine two questions: Is there evidence that pension funds are the “marginal” investors in the United Kingdom, and, if so, how do taxes affect the valuation of dividend income? Given the nature of the tax change we examine, these questions are inevitably linked. We examine the valuation of dividends before and after the tax change by considering the ex-dividend day behavior of share prices. If pension funds were not the marginal investors, then we would anticipate no change in valuation, as all other classes of investors were unaffected by the tax change. However, if pension funds have a significant effect at the mar* Bell is at the Economics Department, Oxford University and Jenkinson is at the Saïd Business School, Oxford University and CEPR. We are grateful for extremely helpful suggestions from the referee, and comments from seminar participants at the U.K. Treasury, Oxford University, and the May 2000 TMR Conference in Barcelona. We alone are responsible for any remaining errors or omissions. THE JOURNAL OF FINANCE • VOL. LVII, NO. 3 • JUNE 2002