MARGINAL STOCKHOLDER TAX EFFECTS AND EX-DIVIDEND-DAY PRICE BEHAVIOR: EVIDENCE FROM TAXABLE VERSUS NONTAXABLE CLOSED-END FUNDS Edwin J. Elton, Martin J. Gruber, and Christopher R. Blake* Abstract—Almost all research on the movement of stock prices on ex-dividend days has found that prices decline by less than the dividend. Though this is consistent with tax effects, several papers have argued that this phenomenon could be caused by market microstructure effects. In this paper we make use of a natural experiment that provides support for the tax explanations of ex-dividend behavior. Some closed-end funds have taxable, and some have nontaxable, dividend distributions. Both types are subject to taxes on capital gains. The implication of this for ex-dividend- day price behavior is very different between these two types of funds if taxes matter. This paper demonstrates that the direction of ex-dividend- day price behavior is consistent with a tax explanation and that ex- dividend-day price behavior changes, as theory would suggest, with changes in the tax law. I. Introduction I n 1970 Elton and Gruber (hereafter E&G) showed that if taxes enter investors’ decisions, then the fall in price on the ex-dividend day should reflect the post-tax value of the dividend relative to the posttax value of capital gains on that day. Because dividends in most time periods are taxed more heavily than capital gains, the theory suggests that if taxes affect investors’ choices, the fall in stock price should in general be less than the dividend, and the drop could be used to infer marginal tax rates. 1 Since 1970, numerous articles have appeared, either questioning or supporting the tax explanation of ex- dividend-day price behavior. These articles (some of which are discussed in more detail in the next section of this paper) generally fall into one of four categories. The first is replication of the E&G tests on non-U.S. markets or on U.S. markets in other time periods. Tests have been conducted using data from more than a dozen countries. A second group of articles reexamines the ex-dividend-day price be- havior around changes in tax laws to see if the change in the ex-dividend-day price drop is related to changes in tax policy. The third group of articles admits an ex-dividend- day price change less than the dividend but says the price change is limited because of arbitrage by short-term traders. Finally, and perhaps most damaging to the tax explanation, there is a series of articles that attempt to show that even in the absence of differential taxes the price of common stocks should fall by less than the dividend on ex-dividend days because of market-microstructure characteristics. This argu- ment is the most troublesome, for it suggests that in the 1970 E&G article and in much of the empirical work which followed, ex-dividend-day price behavior may, in fact, be unrelated to taxes, and much of the profession may have been misled. In this article we test for ex-dividend effects on a sample that has not been previously examined: closed-end mutual funds. What makes this sample exciting is that it contains a set of securities (municipal bond funds) for which the ex-dividend price drop should be greater than the dividend if taxes matter, as well as a set of securities (taxable bonds) for which the drop should in general be less than the dividend. 2 As we show, the difference in the ex-dividend- day effects for these two groups provides evidence for a tax explanation of ex-dividend behavior, for microstructure ar- guments predict a price change less than the dividend for both groups. Furthermore, our sample period, 1988 to 2001, encompasses several large changes in the maximum tax rate on dividends and capital gains. Thus, the tax hypothesis can be further tested by examining ex-dividend-day price be- havior over these alternative tax regimes. The shares in closed-end funds are like any other stock. They trade in organized capital markets, they pay dividends and capital gains. The only difference between these shares and the shares of industrial corporations is that they hold financial assets rather than real assets. This does not affect the way they trade, but it does have interesting implications for the effect of taxes. We show that the behavior of price changes with respect to dividends on the ex-dividend day conforms to the theory that taxes determine the relative value of dividends vis-a `-vis capital gains. This holds both for different types of closed- end funds and for the impact of changes in tax law within each type of fund. These results clearly show that taxes play an important role in determining the ex-dividend-day price behavior of common stocks. This paper is organized as follows: In section II we briefly review some of the discussion of ex-dividend-day price behavior that has appeared in the literature. We also present a discussion of why closed-end funds represent an excellent sample for examining the effect of taxes on ex- dividend-day price behavior. In section III we present the Received for publication August 7, 2003. Revision accepted for publi- cation August 24, 2004. * Stern School of Business, New York University; Stern School of Business, New York University; and Fordham University Graduate School of Business, respectively We would like to thank participants in the MIT-Harvard Public Eco- nomics Seminar and discussants at the American Finance Association, European Finance Association and Financial Management Association meetings for helpful comments. We are especially grateful to Joe Rebo- vitch for help in understanding the details and timing of the tax regimes employed in this paper. 1 See Elton and Gruber (1978) for the implications of the tax hypothesis for optimal portfolio construction, and Elton, Gruber, and Rentzler (1983) for the implications for long-term returns. 2 Green and Rydqvist (1999) study a different investment class, Swedish bonds, that should also have an ex-dividend-day drop greater than the dividend. The Review of Economics and Statistics, August 2005, 87(3): 579–586 © 2005 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/0034653054638337 by guest on 08 June 2021