Ex-day stock pricing for firms in the
Dutch market and the 2007 tax rate
change on Dividend yields
Abstract
This thesis evaluates ex-dividend day stock pricing for firms in the Dutch market by considering the effects of the change in the Dutch tax rate on dividend yields in 2007. As is the case in most markets, stock prices generally fall by less than the dividend amount on ex-dividend day. I find weak but not significant evidence that following the tax rate change in 2007, the mean 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑∆𝑃𝑟𝑖𝑐𝑒 ratio on ex-dividend day went up, in line with what
ex-day stock pricing theories predict.
Name: Enzio Fruijtier Student number: 10438610 Supervisor: Timotej Homar Date: 29-06-2015
Statement of Originality
This document is written by Enzio Fruijtier who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Table of content
1. Introduction 4
2. Dividend yield and capital gains taxation in the Netherlands 5
3. Literature review 6
4. Data 8
5. Methodology 8
6. Results 11
7. Summary and conclusion 13
Introduction
In a perfect capital market, the stock price drop should equal the amount of the dividend on ex-dividend day. If the stock price drop deviates from the dividend amount,
arbitrageurs could make a profit by selling cum-dividend and buying ex-dividend, or vice versa, depending on the amount of the stock price drop compared to the dividend. This would drive the stock price change to be equal to the dividend amount, at which point no more arbitrage profits can be made (Modigliani, Miller 1961). Many empirical
studies(Elton&Gruber(1970), Kalay(1982), Booth&Johnston(1984),
Fedenia&Theoharry(1993), Rantapuska(2008), etc.) on ex-dividend day stock pricing however find that, in most cases, the stock price does not fall by the dividend amount, usually dropping by less than the dividend amount. These findings suggest that there are some market imperfections affecting stock pricing on ex-dividend day. This is relevant for investors, as these imperfections may be used to achieve positive abnormal returns. Indeed, Rantapuska(2008) found that investors in the Finnish market earned 2% on average on their invested capital by overnight trading, making use of this stock pricing anomaly.
The most commonly cited reason for the stock price change deviating from the size of the dividend is that differences in the relative taxation of capital gains and
dividend yields cause investors to prefer dividend income over capital gains or vice versa, influencing the change of the stock price on ex-dividend day.
In this thesis I look at ex-dividend day stock pricing for 84 Dutch firms, evaluating the effect of the Dutch government lowering the tax rate on dividend yields from 25% to 15% in 2007. I try to answer the following question: how did the change in the Dutch tax on dividend yields in 2007 affect ex-dividend day stock pricing in the Dutch market? I compare the mean 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑∆𝑃𝑟𝑖𝑐𝑒 ratio from the period 2000-2006 to the mean 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑∆𝑃𝑟𝑖𝑐𝑒 ratio for the period starting 2007 and ending at the end of May 2015. Most existing theories
predict that this tax change should cause the mean ∆𝑃𝑟𝑖𝑐𝑒
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 ratio to increase. I find very
strong evidence that stock prices in the Dutch market on average fall by less than the dividend amount on ex-dividend day in both periods, in line with what ex-dividend day stock pricing theories predict. I also find suggestive but not significant evidence that, following the tax change, the mean 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑∆𝑃𝑟𝑖𝑐𝑒 ratio went up.
An outline of this thesis is as follows. Section 2 explains the taxes on dividend yields and capital gains in the Dutch market. Section 3 reviews existing literature on ex-day stock pricing. Section 4 describes the data. Section 5 describes the methodology used. Section 6 provides the results. Finally, section 7 summarizes the thesis and concludes.
2. Dividend yield and capital gains taxation in the Netherlands
When Dutch firms issue shares to their shareholders, they withhold 15%(25% before 2007) of the dividend amount, which the firms have to pay as taxes. Dutch investors however, are able to deduct the 15%(25%) withheld taxes paid from the total amount of income taxes that they need to pay, meaning that Dutch investors usually do not pay taxes on dividend yields issued by Dutch firms (Doesum, et al., 2012). Exceptions do exist, however, for example when the total withheld dividend exceeds the total amount of income tax that needs to be paid. This is usually not the case, however, so in general the tax rate Dutch investors have to pay on dividend yields from firms in the Dutch market is zero or close to zero. Foreign investors on the other hand are generally not refunded this withheld tax, or are refunded only partially, depending on their country of residence. Foreign investors, therefore are taxed on dividends at a higher rate than Dutch investors in the Dutch market.
Capital gains on shares in the Netherlands are generally exempt from tax, so the capital gains tax rate is zero for Dutch investors (Doesum, et al., 2012). Capital gain rates
for foreign investors differ per country, though capital gains are generally taxed at a lower rate than dividend yields in almost all countries.
This does not mean that owning stocks is completely tax free for Dutch investors, however. Dutch residents still have to pay taxes on their total wealth, and shares are counted as part of this total wealth (Doesum, et al., 2012). This does not affect the relative taxation of capital gains and dividend yields, only the total taxation of wealth, so this wealth tax plays no further role in the rest of this thesis.
3 Literature review
There are three main theories that use a single marginal investor as the price setter on ex-dividend day: tax-clientele theory, transaction costs theory and price discreteness theory. One of these theories is the price discreteness theory. Bali and Hite(1998) found that stock prices had a tendency to fall by less than the dividend by one tick. While stock prices are constrained to be a multiple of a tick, dividends are not.
When they wrote their paper, tick sizes of $0.125 were quite common. Shortly after their paper was written, the decimalization of stock prices followed, decreasing tick sizes substantially. According to the price discreteness theory, this should mean that ∆P/D ratios converged closer to unity. Graham, Michaely and Roberts(2003) however found the opposite effect: after the decimalization of stock prices, ex-day premiums actually
decreased, providing strong evidence that price discreteness was not the cause of the ex-day premium deviating from one. Price discreteness will therefore not be taken into consideration for the rest of this thesis, as our sample does not contain data from before decimalization.
The tax-clientele theory states that the marginal investor, which is the investor with the strongest tax-induced preferences, determines the size of the stock price drop on ex-day. Based on the relative taxation of capital gains and dividend yields, stock prices will adjust until the marginal investor is indifferent between investing before the ex-day and
investing after the ex-day. The marginal investor can either be an individual investor or a corporation. Elton and Gruber(1970) derived that, if the marginal investor is the
individual investor, he will be indifferent between investing before or after the ex-day if
∆𝑃
𝐷 = (1 − 𝜏𝑑)/(1 − 𝜏𝑐𝑔) (1)
∆P=Stock price drop on ex-dividend day D=Dividend
τd=Marginal tax rate on dividend yields
τcg=Marginal tax rate on capital gains
For the case where the marginal investor is a corporation, Lakonishok and
Vermaelen(1986) derived that a corporation will be indifferent between investing before or after the ex-day when
∆𝑃 𝐷 ≤ 1 + 𝑘𝜏𝑐 1−𝜏𝑐 − 𝑎 𝐷 (2)
K=Portion of dividend a company can deduct from income τc=Tax rate on corporate income
a= Total transaction costs
=Average of the cum-day and ex-day closing stock price
Transaction costs theory, first covered by Kalay(1982), states that the marginal investor is the investor that has the lowest transaction costs. Investors with small transaction costs that face no different taxation on dividend yields and capital gains will be able to trade on stocks going ex-dividend and make a profit on the ∆𝑃𝐷 ratio deviating from one. This
trading should cause ∆𝑃𝐷 ratios to approach unity. Kalay(1982) derived that these arbitrageurs will be indifferent between trading before or after the ex-day when
1 −𝑎𝐷 ≤ ∆𝑃𝐷 ≤ 1 +𝑎𝐷 (3)
If it is indeed the case that the arbitrageur is the marginal investor, and this theory holds, this should lead to a mean ∆𝑃
𝐷 ratio of close to one for the Dutch market. Heath and
Jarrow(1988) however, argue that Kalay’s theory is based on a false premise. Pure arbitrage means that it is possible to make abnormal returns at no risk. This is only
possible if investors can know beforehand with certainty if they should buy cum-dividend and sell ex-dividend or sell cum-dividend and buy ex-dividend, which can only be the
case when the stock price drop is known to be either always less than the dividend or more than the dividend. While stock prices tend to drop by less than the dividend on ex-day most of the time, this is not always the case. Therefore, this trading strategy is not risk free. Because investors are generally risk-averse, investors will need to be
compensated in the form of a risk premium for taking risk, or they will not trade. If the mean ∆𝑃𝐷 ratio is very close to 1, the expected return and therefore the risk premium will
be too small for most tax-neutral investors to be willing to trade.
Armstrong and Hoffmeister(2012) suggest that it may also be the case that no single marginal investor can determine ex-day performance, but that the stock price change on ex-dividend day reflects the tax-induced preferences of multiple investor groups. They find results that are not consistent with the existence of a single marginal investor, but can only occur if the tax-preferences of both corporations and investors influence ex-day stock pricing.
Rantapuska(2008) was able to research individual investor behavior extensively for the Finnish market. He found that only a small portion of investors actually use ex-day stock pricing to their advantage and that most investors did not act in a tax-optimal
manner. He also found that, on average, investors using overnight trading between cum- and ex-dividend day get a return of 2% on their invested capital, implying that not acting in a tax-optimal manner is costing a lot of investors money.
4. Data
The data set contains stock price and dividend information for 84 Dutch firms for the period spanning from the beginning of the year 2000 to the end of May 2015. The sample contains only firms that were listed on either the AEX-, AMX- or AScX index during this period. Firms traded in the Dutch market that do not fit this criteria are not contained in the sample, as these firms tend to be traded infrequently or are international firms, where applying Dutch tax rates to explain ex-dividend day stock pricing does not make sense. This initial sample consists of 1106 ex-day events. From this sample, I eliminate all observations with share prices trading at €1 or lower and all observations with dividends of €0.01 or lower. In order not to confuse the announcement effects with ex-day pricing effects I also removed observations where the gap between the dividend announcement
and the ex-day was 5 days or less. I also don’t consider stock splits. After removing these observations, 1101 ex-day events remain.
5. Methodology
I will analyze ex-dividend day stock pricing for the firms in the Dutch market for two periods. The first period I analyze is the period from 2000 to 2006. The second period I analyze is the period from 2007 to the 28th of May, which is the period following the tax rate change on dividend yields for Dutch firms in 2007. For these two periods, I will compare the actual mean ∆𝑃𝐷 ratio to the ∆𝑃𝐷 ratios that would be expected according to Elton and Gruber(1970).
In order to be able to evaluate abnormal stock price returns on ex-dividend day, I first need to control for the normal returns. For this, the Capital Asset Pricing
Model(CAPM) is a useful tool. I used the CAPM to calculate the stock alfas and betas for every firm in the dataset individually. For every firm, I calculate two alfas and two betas: one alfa and beta for the period 2000-2006 and one alfa and beta for the period from 2007 to May 2015. These alfas and betas are then used to compute the normal returns. These normal returns are then subtracted from actual returns, providing the abnormal returns. To evaluate ex-day stock pricing I look at the ∆𝑃𝐷 ratio for both periods, adjusted to control for normal returns. To compute this ratio I subtract normal price changes as predicted by CAPM from actual price changes and divide this amount by the dividend amount for all ex-day events. The mean ∆𝑃
𝐷 ratio is sensitive to extreme observations that can occur
because of the size of dividends being very small or because of extreme events happening on ex-dividend day. Because big outliers can skew the mean of this ratio significantly, I use winsorization with p=0.01. Winsorization replaces the top 1% of highest values with the value at the 99th percentile and the bottom 1% with the value at 1st percentile. Using winsorization dropped the standard error of the ∆𝑃𝐷 ratio significantly.
As stated before, Elton and Gruber(1970) derived the following formula to explain ex-dividend day stock pricing:
∆𝑃
If Dutch investors investing in the Dutch market are the marginal investor, this equation implies a ∆𝑃𝐷 ratio of one or slightly under one on ex-dividend day for both periods. Note
that Kalay(1982) also predicts a ∆𝑃𝐷 ratio of 1 if there are no transaction costs. This brings me to the first hypothesis that I test:
Hypothesis 1: H0:
∆𝑃
𝐷 = 1 H1: ∆𝑃
𝐷 ≠ 1 for both periods
If foreign investors are the marginal investor, the expected ∆𝑃𝐷 ratio is uncertain as their tax rates differ depending on the country they reside in. However, in order to
analyze the effect of the tax rate change in 2007, I make two assumptions. The first assumption is that the tax rate on capital gains for the foreign investors equals zero. This is reasonably realistic, as capital gains on the sale of stocks are not taxed in many
countries. The second assumption is that the tax rate on dividend yields for foreign investors is exactly 25% in the first period, and exactly 15% in the second period. This assumption is less realistic. In some countries, the tax rates on dividend yields will be lower than this, for some they will be higher. The ∆𝑃
𝐷 ratio in the period from 2000 to 2006
should be 0.75 given these assumptions and 0.85 in the period from 2007 to May 2015, if these foreign investors determine marginal pricing on ex-dividend day. I will test both of these hypotheses as follows:
Hypothesis 2: H0: ∆𝑃 𝐷 = 0.75 H1: ∆𝑃 𝐷 ≠ 0.75 for period 1 Hypothesis 3: H0: ∆𝑃 𝐷 = 0.85 H1: ∆𝑃 𝐷 ≠ 0.85 for period 2
While the ∆𝑃𝐷 ratio is expected to stay the same in both periods if Dutch investors determine ex-day stock pricing for Dutch firms, the ∆𝑃𝐷 ratio is expected to go up if foreign investors are the ones determining ex-dividend day pricing for Dutch firms. If the increase in taxation for foreign investors has an effect on ex-dividend day pricing, the
∆𝑃
𝐷 ratio should then be higher in the period from 2007 to May 2015 than in the period
from 2000 to 2006. This is the last hypothesis I will test: Hypothesis 4:
H0: ∆𝑃
𝐷 same in both periods H1: ∆𝑃
𝐷 higher in period 2 than in period 1.
6. Results
Table 1
Average price drop on ex-dividend day
Period ∆P/D ratio Standard error 95% confidence interval 2000-2006 0.69333 0.05891 0.57761 0.80905 2007-May2015 0.76467 0.04210 0.68198 0.84736 2000-May2015 0.72955 0.03608 0.65876 0.80034 Table 2 Hypotheses Hypothesis Period H0 H1 ∆𝑷 𝑫 ratio t-statistic 1 2000-2006 ∆𝑃 𝐷 = 1 ∆𝑃 𝐷 ≠ 1 0.69333 (0.05891) 5.21*** 2007-May2015 ∆𝑃 𝐷 = 1 ∆𝑃 𝐷 ≠ 1 0.76467 (0.04210) 5.59***
2 2000-2006 ∆𝑃 𝐷 = 0.75 ∆𝑃 𝐷 ≠ 0.75 0.69333 (0.05891) -0.96 3 2007-May2015 ∆𝑃 𝐷 = 0.85 ∆𝑃 𝐷 ≠ 0.85 0.76467 (0.04210) -2.02** 4 Both No change in ∆𝑃 𝐷 ∆𝑃 𝐷 increases Change= 0.07013 0.99
*Significant at the 0.1 level **Significant at the 0.05 level ***Significant at the 0.01 level
Table 1 and table 2 summarize the results. I find very strong evidence that stock prices in the Dutch market on average fall by less than the dividend amount in both periods, in line with what theories considering tax-induced clienteles predict and rejecting H0 in
hypothesis 1. This result is therefore significantly different from what the ∆𝑃
𝐷 ratio should
be according to Kalay(1982), which indicates that the arbitrageur is not the single marginal investor setting the prices on ex-dividend day in the Dutch market. This is also strong evidence against Dutch investors solely determining ex-day stock pricing. This finding suggests that a tax neutral investor could earn abnormal returns by buying shares cum dividend and then selling the shares on ex-dividend day. As Heath and Jarrow(1988) argue, however, this would not be true arbitrage: while stock prices generally fall by less than the dividend amount on ex-dividend day, they do sometimes fall by more than the dividend amount. This strategy therefore still contains risk. On average though, provided that the transaction costs are not too high, this trading strategy should still earn
abnormally high returns.
I do not find strong enough evidence to be able to reject that the ∆𝑃
𝐷 ratio equals 0.75 in
period one. This means it is quite possible that foreign investors are indeed the single marginal investor determining ex-day stock pricing in the period from 2000 to 2006. I am, however, able to reject the hypothesis that the ∆𝑃𝐷 ratio equals 0.85 in period 2 at a
significance of 5%. So while it is possible that the foreign investors determine ex-day stock pricing in period 1, in period 2 this is no longer the case.
I find weak evidence that the mean ∆𝑃𝐷 ratio increased after the tax rate on dividend yields, though it is not statistically significant. The fact that this is not significant could be caused by the sample size: the standard error of the adjusted ∆𝑃𝐷 ratio, which is 0.036 is
pretty large. Perhaps if the sample size were bigger, the effect of the tax rate change on the ∆𝑃𝐷 ratio might have been significant, as this would decrease the magnitude of the standard error. The lack of a significant effect of the tax change could perhaps also be attributed to the fact that, for most Dutch investors, the tax rate on dividend yields did not change, because the withheld tax can be deducted from the income tax they have to pay. The proportion of investors that were affected by this tax rate change may have simply been too low to significantly affect pricing. Even though the effect is not statistically significant, the change is large enough that it still seems somewhat likely that the tax rate change had at least some effect on ex-day stock pricing. Whitworth and Rao(2005) analyzed numerous tax rate changes for U.S. firms and found that the tax changes had a very significant effect on ex-day stock pricing. Their sample was much larger and they researched a different market, but it does indicate that tax changes tend to have an impact on ex-day stock pricing, making it seem probable that the Dutch tax rate change on dividend yields in 2007 had some effect on ex-dividend day pricing as well.
Interestingly, the ∆𝑃𝐷 ratio is lower than the ∆𝑃𝐷 ratio predicted by Elton and
Gruber’s(1970) formula in both periods for both investor groups, though the difference is not significant in period 1. Perhaps, the foreign investors, like Heath(1988) suggested was the case for arbitrageurs, need to be compensated with a risk premium in order for them to trade. If this is the case, this might explain the actual ∆𝑃𝐷 ratios being lower than what they are expected to be. Transaction costs may have also had an effect. Another
explanation for this finding is that perhaps, as Rantapuska(2008) found was the case in the Finnish market, investors often do not act in a tax-optimal manner. If most investors do not correctly take taxes on dividend yields and capital gains into account when trading, the ∆𝑃
𝐷 ratios predicted by Elton and Gruber(1970) may not be reached.
7. Summary and conclusion
I evaluated the effect of the 2007 Dutch dividend yield tax rate change from 25% to 15% on ex-dividend day stock pricing for Dutch firms. I found very strong evidence that stock prices of firms in the Dutch market fall by less than the dividend amount on ex-dividend day for both the 2000-2006 period and the 2007-mid 2015 period, as is the case in most
markets and in line with what theories on ex-day stock pricing predict. I also found suggestive but not significant evidence that the the mean ∆𝑃𝐷 ratio went up following the tax rate change in 2007. Interestingly, actual ∆𝑃𝐷 ratios for both periods were lower than expected, though not significantly so in period 1. This could perhaps have been caused by the existence of a risk premium, transaction costs or investors not acting in a tax-optimal manner.
8. References
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