Taxation of Capital Gains and the Behavior of Stock Prices Over the Dividend Cycle
Rutgers, The State University of New Jersey - Accounting & Information Systems
Rutgers University; School of Business-Camden
The American Economist, Vol. 27, No. 1, pp. 13-22, Spring 1983
By limiting their attention to the effect of capital gains tax on the price asked by mid-cycle sellers, Elton and Gruber (Review of Economics and Statistics v.52, 1970) overlook a parallel effect of capital loss credit on the bid price offered by mid-cycle buyers. We show that unequal marginal tax rates on capital gains and losses create two distinct price paths with a growing bid-ask spread between them. The dividend cycle ends with a corresponding drop of the dual price to a temporary common ex-dividend price. As perceived by shareholders, the mid-cycle bid-ask spread created in this fashion may add a significant trading cost beyond the observed market-price spread. Our analysis has important implications for shareholders' optimal timing of trade, the firm's optimal frequency and timing of dividends within the year, and government tax policy. A government seeking to tax capital gains should maintain parity between the tax rates of gains and losses to avoid the introduction of tax-induced trading costs. Absent rate parity, the firm should accommodate shareholders by following a predictable dividend schedule and avoiding extended intervals between dividends. Under this scenario, shareholders can avoid tax-induce trading costs by limiting their transactions to ex-dividend days.
Number of Pages in PDF File: 10
Keywords: stock price over the dividend cycle, stock pricing with personal taxes, stock bid-ask price spread, ex-dividend trading, stock market efficiency
JEL Classification: G12, G18, G35, G38, H21, H31, H32Accepted Paper Series
Date posted: February 6, 2008 ; Last revised: October 8, 2013
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