Effects of dividend policy and taxes on capital market equilibrium

Kaplanis, Costas (1985) Effects of dividend policy and taxes on capital market equilibrium. Doctoral thesis, University of London: London Business School.

Abstract

This study is concerned with the effects of the differential taxation of dividends and capital gains on equity prices. In particular, the following areas are examined: (i) The equilibrium share price fall off on the ex dividend day assuming tax exempt and ordinary investors trading around that day face the risk of being taxed as a dealer. This analysis incorporates some of the features of the 1970 UK Anti-Avoidance Legislation. (ii) The effect on equilibrium prices and on investor clienteles when, in addition to differential taxation, the realistic assumption of short sale constraints is imposed. (iii) A test of the presence of tax effects in the pricing of UK equities in the period 196o-i984 (iv) Development of a new method of testing for tax effects using option prices and use of this method in the UK (1979-1984) The principal findings of the study can be summarised as follows: (a) Under the assumptions of (i) above, investors' marginal tax rates cannot be inferred from the fall off. Further, the model predicts that the fall off in the UK should be lower after 1970. (b) The simulation of short sales restrictions showed, among other results, that (i) A "beta clientele effect" can, under certain circumstances, be as strong as, or even outweigh, the commonly assumed dividend clientele effect; and (ii) A supply equilibrium with positive dividends does not, in general, exist. (c) There is a strong dividend effect in the UK (196o-1984) but, although there is some evidence in favour of a tax effect, the estimates of the dividend coefficient were too high to be interpreted as weighted average tax rates. (d) The results of the test using option prices were consistent with the presence of tax effects.