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International Tax and Public Finance

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18.05.2017

Dividend taxes and stock volatility

verfasst von: Erin E. Syron Ferris

Erschienen in: International Tax and Public Finance | Ausgabe 2/2018

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Abstract

How do dividend taxes affect stock volatility? If a risk-averse executive faces price risk through his incentive contract, changes in stock volatility due to dividend taxes may increase agency costs and therefore decrease overall welfare. In this paper, I use a decrease in dividend taxes as a natural experiment to identify their effect on the firm’s idiosyncratic stock return volatility. Stock volatility decreased after the tax cut for firms at which executives have larger sensitivity to stock price in their incentive compensation package relative to firms at which executives have a smaller sensitivity. Therefore, with risk-averse executives and risk-neutral shareholders, dividend taxes may exacerbate agency costs. The increase in agency costs will decrease shareholder welfare, which can be partially offset by the use of options in the employment contract.

Vorheriger Artikel Capital taxation, investment, growth, and welfare

Nächster Artikel The magic of layoff taxes requires equilibrium stability

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There is a large theoretical literature starting with Jensen and Meckling (1976) that demonstrates the tradeoff between incentives and risk. In a traditional agency model, the executive takes firm risk as given, and incentives are negatively correlated with firm risk, which Jin (2002), Aggarwal and Samwick (1999), Core and Guay (1999), and Core and Guay (2002b) empirically evaluate.

See Graham (2003), Auerbach (2002), Graham (1996), and MacKie-Mason (1990) for theoretical and empirical implications.

If the firm pays dividends, then it will have less cash on hand to use for overinvestment by the executive. Christie and Nanda (1994) find lower dividend growth in firms with higher agency costs, as the firms had high dividends originally to mitigate some of the high agency costs. La Porta et al. (2000) and Fenn and Liang (2001) also find evidence in support of the agency theory.

See Chetty and Saez (2010) and Gordon and Dietz (2006) for examples related to a dividend tax change.

See Auten et al. (2008) for a detailed description of all the tax changes associated with the 2003 law.

More traditional finance models could also be adapted to show the same type of concerns.

The correlation could be either positive or negative depending on how diversified the firm is.

Note the model could also be adjusted to allow the profitable investment, I, to occur in the future. The results depend on the investment leading to a positive return and volatility that is correlated with the investment.

See Chetty and Saez (2010) for evidence.

$\gamma $ does not depend on A, so J depends on A only if $\alpha $ changes.

The manager also takes home, after taxes, less of the firm’s payoff.

The equation does not include the third derivatives, with the assumption that they are small (or zero as in the quadratic form in the example below).

If returns on investment are close to linear while the second derivative of volatility is very positive, this assumption may not hold.

$f(I)=\frac{1}{10}(2I-\frac{1}{2}I^2)$ and $V(I)=\frac{1}{20}(2I-\frac{1}{2}I^2)$.

These percentages were chosen to match the order of magnitude difference between the average share in the bottom and top price quintiles in the empirics.

The number of firms in CRSP may differ, as the matching CRSP ID changes over time for a few firms in the sample.

As in Malmendier and Tate (2009), I define market-to-book value as the ratio of market value of assets to book value of assets. Book value of assets is total assets at the end of the quarter. Market value of assets is defined as book value of assets plus market equity minus book equity. Market equity is defined as common shares outstanding at the end of the quarter times quarter closing price. Book equity is calculated as stockholders’ equity at the end of the quarter [or the first available of common equity outstanding plus preferred stock par value or total assets minus total liabilities ] minus preferred stock liquidating value.

The authors use a measure developed by Dechow and Dichev (2002) that is based on an estimate for total accruals.

Consider two stocks that increase exactly $1 every other day. On the days when the stocks do not increase by $1, they decrease exactly $1. After a quarter (assuming an even number of days), the stocks would have the same prices as at the beginning of the quarter. If one stock has a high price and one has a low price, the volatility of the stock price will be exactly the same for the two stocks. However, the volatility of the return would be much higher for the stock with a low price compared with the stock with a high price. If the executives of both the high- and low-priced stocks have the same number of shares of the high- and low-priced stocks, the volatility of both executives’ income is the same. However, if the executive of the low-priced stock has more shares, the volatility of his income is higher.

See Fama and French (1993) for a full description of the model.

See Campbell et al. (2001), Bennett et al. (2003), Xu and Malkiel (2003), Fink et al. (2010), Brown and Kapadia (2007), Wei and Zhang (2006), Irvine and Pontiff (2009), Comin and Philippon (2005), and Rajgopal and Venkatachalam (2011) for several examples of explanations.

In results not shown in the paper I included industry-time effects. The results are similar to the tables in the paper. I also considered a balanced panel of firms. I found similar results.

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Titel: Dividend taxes and stock volatility
verfasst von: Erin E. Syron Ferris
Publikationsdatum: 18.05.2017
Verlag: Springer US
Erschienen in: International Tax and Public Finance / Ausgabe 2/2018
Print ISSN: 0927-5940
Elektronische ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-017-9455-2

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