Ex-Dividend Behaviour and the Clientele Effects: Evidence Based on Canadian and US Dividend Tax Cuts

Abstract

We investigate the ex-dividend behaviour of TSX listed Canadian firms during a period when both U.S and Canadian governments cut taxes on dividend income. We test whether the tax differential between dividends and capital gains affects the stock price drop ratio on ex-dividend date. Using quarterly dividend date from 2002-2007, we also investigate the existence of dividend tax clientele effects. We provide empirical evidence that relative tax differential of dividends and capitals gain has significant effects on investor behaviour on ex-dividend date consistent with the hypothesis that dividend tax affects equity values. We also find evidence that Canadian Investors, not the US investors, are the marginal investor for Canadian securities. We suggest that the use of appropriate tax variables is essential for detecting the relationship between tax and ex-dividend day behaviour, as our study has shown that tax relevance hypothesis upholds when the marginal tax rate of Canadians is introduced as tax variable, unlike when that of the US is employed. These findings undermine the claims in some prior studies that tax is not relevant on ex-dividend day. Our study also documents dividend clientele effect using Canadian data. We provide evidence that dividend yield is positively related to drop ratio as in Elton and Gruber (1970) and inversely related to implied tax rates consistent with investors in high tax bracket being attracted to low dividend stocks and investors in low tax bracket preferring high dividend stocks. This clientele effect persists across different measures of drop ratio.