Ticks and Tax: The Joint Effects of Price Discreteness and Taxation on Ex Dividend Day Returns

Abstract

We examine ex-dividend day stock price behavior before and after the NYSE converted from discrete (1/16ths) to decimal pricing systems in early 2001, as well as the effect of equalizing the federal income tax rates on dividend and long-term capital gain income in May 2003. Prior literature reports a robust empirical result that share prices decrease on the ex-dividend day by less than the amount of the dividend, but there is little agreement about whether this incomplete price adjustment is caused by share price discreteness, differential taxation of dividend income relative to capital gains, or other factors. Two recent studies, Graham, Michaely and Roberts (2003) and Jakob and Ma (2004), report that declining price discreteness (e.g. from 1/16ths to decimal pricing) had no material effect on the cum- to ex-day price-drop-to-dividend ratio. Although we report similar findings for the price-drop ratio, we find that ex-day abnormal returns declined significantly as a result of decimalization in 2001, and declined further in response to tax rate equalization in May 2003. Thus, our findings support the view that both price discreteness and differential taxation affect ex-dividend day stock price behavior.