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Marginal Stockholder Tax Rates and the Clientele Effect

Author(s): Edwin J. Elton and Martin J. Gruber


Source: The Review of Economics and Statistics, Vol. 52, No. 1 (Feb., 1970), pp. 68-74
Published by: The MIT Press
Stable URL: http://www.jstor.org/stable/1927599 .
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MARGINAL STOCKHOLDER TAX RATES
AND THE CLIENTELE EFFECT
Edwin J. Elton and Martin J. Gruber*
T HE determination of marginal stock- in order to accurately determine the firm's
holder tax brackets is an important and optimal investment policy.
unresolved issue in the economic literature. Knowledge of marginal stockholder tax
Marginal stockholder tax brackets play an im- brackets will also allow us to draw inferences
portant role in stock valuationmodels [ 1, 6, 14], about the importanceof dividend policy.' Such
in normative investment and dividend policy inference could be made if we find a strong
models [11, 16], and in descriptive capital allo- relationship between corporate dividend policy
cation models [ 7, 8, 10, 12]. and investor tax rates. The establishment of
The purpose of this paper is to present and this relationship would provide evidence that
test a method of determining marginal stock- supports the clientele effect of Miller and Mo-
holder tax brackets and to explore the implica- digliani [13] (each firm is assumed to have a
tions of our findings for corporate investment body of stockholders who find its dividend
policy, corporate dividend policy, and the as- policy optimum). Further, such a finding means
sumption of market rationality. that a change in dividend policy might cause a
In the first section of this paper we expand change in clientele and this could be costly.2
upon the reasons for studying marginal stock- The final reason for studying the ex-dividend
holder tax brackets. In the next section we behavior of common stock is that it can provide
show how marginal stockholder tax brackets evidence of rationality. Most of the work in
can be inferred from the ex-dividend behavior investment theory assumes rationality on the
of common stock. In the third and fourth sec- part of stockholders (for example, almost all
tions we compute marginal stockholder tax valuation models). This paper provides evi-
brackets and discuss their implications for capi- dence that a theory based on rational stock-
tal theory. holder behavior is really descriptive of their
behavior.
Reasonsfor the Study Despite the importance of marginal stock-
holder tax rates to financial theory and practice
While stockholder tax brackets are interest-
there have been few attempts to identify stock-
ing in themselves, they are of primary impor-
holder tax brackets. Those attempts which
tance because of the role they play in estab-
have been made have relied on either a survey
lishing the firm's cost of capital. In capital
of a firm's stockholders or the collection of tax
theory the cost of retained earnings is defined
data for all stockholders in the economy.
as that rate which makes a firm's marginal
Neither of these methods attempts to identify
stockholders indifferentbetween earnings being
tax rates for stockholders at the margin. In
retained or paid out in the form of dividends.
addition, the latter method implicitly makes the
Because dividends are taxed at a different rate
than capital gains the cost of retained earnings 1 A distinction has been drawn between investment
is a function of the marginal stockholder's tax policy and dividend policy. The same investment policy
bracket. This tax rate is therefore necessary can be met by using different combinations of retained earn-
ings and external financing. The question remains as to
* This paper has been presented at the Econometric Society whether dividend policy per se affects firm value. See [13].
2 One type of cost would be the transaction costs incurred
Meetings, Fall 1968 and Operations Research and Manage-
ment Science Meetings, May 1, 1969. The research for this by both buyers and sellers as the firm's clientele changes.
paper was started at the Harvard Seminar on Research in Furthermnore,there should be at least a short run unfavor-
Finance, sponsored by the Ford Foundation in 1967 and able price movement as the change in dividend policy is
continued support was provided by the Office of Research, more apparent to those investors who find it less favorable
Schools of Business, New York University. Computational (present stockholders) than to those who find it more
assistance was provided by William O'Neill and Constantine favorable. For an estimate of the effect of a change in
Fliakos. We would like to thank Michael Keenan and clientele on a firm's cost of retained earnings, see Elton and
William O'Neill for helpful comments and suggestions. Gruber [5].

[ 68 ]

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MARGINAL STOCKHOLDER TAX RATES 69
assumption that the tax rates of stockholders in PA= Priceof the stock on the ex-dividend
all corporations are identical. day.
Pc= Price at which the stock was pur-
chased.
The RelationshipbetweenEx-dividendBehavior t, = The tax rateon ordinaryincome.
and StockholderTax Rates t, = The capitalgainstax rate.
The ex-dividend behavior of a corporation's D = The amountof the dividend.
common stock should be related to the tax rates If a shareholder were to sell his stock in a
of its marginal stockholders.3 corporation before it goes ex-dividend his per
A stockholder selling stock before a stock share wealth would be equal to the price he re-
goes ex-dividend loses the right to the already ceives for the stock (PB) minus the tax he must
declared dividend. If he sells the stock on the pay on any capital gain incurredby owning the
ex-dividend day he retains the dividend but stock (tC(PB -Pc))-
should expect to sell it at a lower price (because If he were to sell on the day the stock goes
of this dividend retention). In a rational mar- ex-dividendhis wealth per share would be equal
ket the fall in price on the ex-dividend day to the dividend (D) times one minus his mar-
should reflect the value of dividends vis-a-vis ginal tax rate on ordinary income (1 - to) plus
capital gains to the marginalstockholders.Since the after tax return on the sale of the share
dividends and capital gains are taxable at dif- (PA - tO(PA - P0)). For him to be indifferent
ferent rates, the relative tax rate on these two as to the timing of his sale, the wealth received
types of income affect the decision. If this from either course of action must be the same.
formulationof the ex-dividendbehavior of com- That is: 4
mon stocks is correct, then one can infer mar- PB - tc (PB - PC) = PA - te (PA - PC)
ginal stockholder tax brackets from observing + D (1 -to) (1)
the ex-dividend behavior of common stocks. Rearranging (1) we get 5
This will now be done more formally. PB - PA 1-to (2)
Starting with the premise that the stockhold- D 1-t(
er wishes to maximize his after-tax wealth we
can derive an expression between the ex-divi- The statistic (PB - PA)/D represents the ex-
dend behavior of common stock prices and the dividend behavior that would cause a stock-
marginal tax rates of marginal stockholders. holder with a particular set of tax rates to and
t, to be indifferentas to the timing of purchases
Let: PB = Price on the day before the stock goes and
sales of common stock. For the market to
ex-dividend.
be in equilibrium the price movement on the
3Discussion of the ex-dividend behavior is not new in ex-dividend day must be such as to leave pros-
the financial literature [see 2, 3, 151. A large part of the pective (marginal) buyers and sellers of the
literature states that the price of a share of stock should,
and does, fall by the amount of the dividend on the ex- 4Actually, both sides of this equation should be adjusted
dividend day. The proponents of this approach usually state for the transaction costs incurred in selling stock. The in-
that the assets per share fall by the amount of the dividend, cremental transaction costs are the transaction costs on the
and thus the price per share should fall by this amount. decrease in stock price. Elsewhere [4] we have argued that
The wide acceptance of this approach is best illustrated by 1 per cent might be a reasonable estimate of transaction
its being institutionalized in the regulation of the New costs. Since the reduction in price on the ex-dividend day
York Stock Exchange. At the opening of the ex-dividend is our statistic, our statistic could be off by 1 per cent.
day all buy and sell orders on the specialists' books are 'A similar conclusion is reached if the decision is analyzed
lowered by the amount of the dividend. If our model is from the buyers side. In this case if the buyer purchases the
correct, this should in general work to the disadvantage of stock before the ex-dividend day then he receives the stock
those individuals with offers on the specialists' books. If the and the after-tax value of the dividend. If he buys the day
seller has an ordinary income tax rate greater than zero the the stock goes ex-dividend he receives the stock, pays a
value of his stock should have dropped by less than the reduced price and incurs an increased tax liability. Setting
amount of the dividend. up the above in equation form and rearranging we would
Although most theoretical analysis would indicate other- again derive (2) with one qualification. Since the payment
wise, the published empirical work on the ex-dividend of the tax liability is delayed, the denominator of (2) is
behavior of common stock indicates that the price has fallen reduced. Given reasonable time horizons this should not
by less than the amount of the dividend. This tendency significantly affect the magnitude of the implied tax bracket.
while present in all previous tests has not proved to be Evidence that time horizon is generally short is contained in
statistically significant. Ortner [14].

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70 THE REVIEW OF ECONOMICS AND STATISTICS
stock indifferent as to whether they buy before is less than 0.015.8 Furthermore, the implied
or after the stock goes ex-dividend. If the ex- average marginal tax bracket for stockholders
pected ex-dividend price was either too high or on the New York Stock Exchange seems rea-
too low marginal buyers and/or sellers would sonable. Our estimate of 36.4 per cent agrees
change the timing of their purchases or sales closely with the results reported by Jolivet [9].
until stock prices were in equilibrium. That is, He attempted to determine the marginal tax
until their after-tax wealth would be the same rates that would be paid by analyzing historic
whether they sold before or after the stock went tax returns. He estimated the tax rate to be 36
ex-dividend. The statistic (PB - PA)/D must per cent for the year 1965.9
then reflect the marginal tax rates of the mar- Our use of closing prices on the ex-dividend
ginal stockholders and one should be able to day might raise questions of bias. A whole
infer these tax rates by observing (PB - PA)/D. trading day has elapsed since the stock went
This is what we shall do in the next section. ex-dividend and part of the price movement we
attribute to tax effects might actually be due to
Tests of Our Statistic a systematic shift in market prices. For ex-
In order to test our hypothesis, we examined ample, if the market increased in price on the
the behavior of all stocks listed on the New day a stock sold ex-dividend, PA would tend to
York Stock Exchange that payed a dividend increase, decreasing the value of our statistic,
during the period April 1, 1966 to March 31, and contributing to the fact that our statistic
1967, and were traded on both the ex-dividend appears to be significantly different from one.

PB - PA a
TABLE 1.- DATA ON THE STATISTIC
D
Standard Probability Implied
Number of Deviation True Mean Is Tax
Observations Mean of Mean One or More Bracket
Raw Data 4148 .7767 .0990 .013 36.4
Data Adjusted by Index 4148 .7868 .0875 .0075 35.1

PB PA (1-to)
a
D (1 -t)
b to will be one-half of to or 25 per cent, whichever is lower. For any particular ordinary income tax rate one and only one capital gains
tax rate is appropriate. For example, in table 1 the assumption that the capital gains tax is one-half the income tax rate holds because the im-
plied ordinary tax rate is less than 50 per cent.

day and the prior day.6 We defined PB as the The presence of a bias favorable to our hy-
closing price on the day before a stock went pothesis was checked in two ways. First, the
ex-dividend. PA was measured by the closing movement of the New York Stock Exchange
price on the ex-dividend day. We used closing index during the period we calculated our sta-
rather than opening prices because all orders tistic was examined.10 As can be seen from
on the specialists' books are adjusted by the 8From the central limit theorem, the mean is normally
amount of the dividend. Consequently,the first distributed with a standard deviation equal to the standard
trade is likely to be a biased estimate of the deviation of the population divided by the square root of
the number of observations. This result is used to test the
equilibriummarket price. Since we had no way statistical significance of our statistic.
of handling this bias, we had to reject opening 'Weston and Brigham [171 made an earlier attempt to
prices.7 define stockholder tax brackets using a method analogous to
Jolivet. They found a rate of 46 per cent for the year 1965.
Table 1 lists the average value of the statistic Neither of these results are fully comparable with ours.
(PB - PA)/D for our entire sample. The proba- Both authors exclude institutional investors from their
bility that the statistic has a value of one or studies and both look at a weighted (by ownership) average
tax rate. Nevertheless, their estimates can be considered as
more (price fell by the amount of the dividend) defining a general area in which we would expect to find
marginal tax rates.
6Foreign corporations and closed end mutual funds were '0The New York Stock Exchange index is not the ideal
eliminated f-rom the sample. index for our purposes. We would like to have an index
7Problems, because of movements in the market between that weights equally a movement in any stock's price. Un-
opening and closing prices, will be discussed shortly. fortunately, the New York Stock Exchange index weights

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MARGINAL STOCKHOLDER TAX RATES 71
TABLE 2. - MOVEMENT OF NEW YORK STOCK ClienteleEffect
EXCHANGE INDEX
Having inferred the average marginal tax
Index Index
Date Value Date Value rate for New York Stock Exchange firms let us
April 1 1966 48.76 November 1 1966 43.49 see if we can disaggregate the results and find
May 1 1966 49.23 December 1 1966 43.42 the marginal stockholder tax rates for firms
June 1 1966 46.51 January 1 1967 43.74 with different characteristics. In particular, let
July 1 1966 46.36 February 1 1967 47.24 us see if the dividend policy of a firm affects the
August 1 1966 44.60 March 1 1967 48.03 tax rate of its marginal stockholders. This
September 1 1966 41.94 March 31 1967 49.52 would be useful information for it would aid in
October 1 1966 40.42
predicting the tax rate of any firm's marginal
stockholders,and at the same time it would pro-
table 2, the index increased during six months vide strong evidence as to the existence of the
and decreased during six months. Furthermore, Miller and Modigliani clientele effect.
its ending level 49.52 is quite close to its open- In order to test the presence of the clientele
ing level of 48.76. These two reasons are in effect, two variables were hypothesized which
fact why we selected this period of time. How- should affect stockholder's desire to invest in a
ever, it is still possible that stocks went ex-divi- company. The first was the firm's dividend
dend primarily on days the market was increas- yield. The lower a firm's dividend yield the
ing. To check this we did the following. We smaller the percentage of his total return that a
counted the number of stocks that went ex-di- stockholder expects to receive in the form of
vidend on a particular day and multiplied this dividends and the larger the percentage he ex-
number times the change in the New York pects to receive in the form of capital gains.
Stock index.11 For the sample year this yielded Therefore, investors who hold stocks which
a net positive change of $8.30 in 4,148 observa- have high dividend yields should be in low tax
tions or about two tenths of a cent per stock. brackets relative to stockholders who hold
Although this would tend to decrease our sta- stocks with low dividend yields.
tistic this is so small that it should have a mini- The second variable that we hypothesized
mal influence on our results. might affect the ex-dividend behavior of com-
To further control against any problem of mon stocks was the payout ratio. Firms that
bias we adjusted our data by the market index. paid out a high percentage of their earnings as
That is, we took the price on the ex-dividend dividends would, all other things being equal,
day and multiplied it by the ratio of the index grow (both in terms of market price and earn-
on the day before the stock goes ex-dividend to ings) at a slower rate than firms which retained
the index on the ex-dividend day. We then re- a larger percentage of earnings. Thus, the high
computed the results. As can be seen from table payout firm should attract stockholders in rela-
1, our results remain essentially the same. The tively lower tax brackets than the low payout
test statistic is significantly less from one at the firms.
0.01 level and the inferred marginal tax bracket Tables 3 and 4 present the tests of these two
becomes 35.1 per cent.'2 hypotheses. In each table all observationswere
divided into deciles according to the variable
price movements by the total market value of the firm's
stock. Although this means the index is not ideal, it is closer which was supposed to account for the ex-divi-
to what we need than any daily index we know of.
" One could argue that since the ex-dividend day affects
dend behavior of the stock (dividend yield in
table 3 and payout in table 4). For each decile
the index, the index understates the "true" movement of the
market. Fortunately, the number of stocks going ex-dividend the mean of both the variable hypothesized as
on a particular day are just not that large. For example, in accounting for ex-dividend behavior and the
the last quarter the largest day had 63 stocks meeting our
criteria, 7 days had more than 40 stocks and the majority
statistic used to measure ex-dividend behavior
bad 20 or less. were computed. Spearman's rank correlation
12 For firms paying very small dividends (PB - PA)/D is coefficientwas then used to judge the extent of
occasionally very large. We eliminated various groups of
low dividend paying stocks and examined the effect on our
the relationshipbetween these two variables. If
results. The only effect was to reduce the variance. the relationship is statistically significant we

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72 THE REVIEW OF ECONOMICS AND STATISTICS
can conclude that there is a clientele effect pres- statistic rose continuously as the dividend yield
ent in the market.13 went up.'5
In tables 4 and 5 we have also calculated the The relationship between implied tax brack-
implied tax bracket associated with each decile. ets and dividend yields can be seen by examin-
Once again, we employed the central limit theo- ing the third and last column of table 3. The
rem to calculate the probability that the ex-di- tax bracket in general decreases as the dividend
vidend price really fell by less than the amount yield at which the stock sells increases. The
of the dividend. fact that the first is out of line may simply be a
The results presented in table 3 are quite result of chance alone given the magnitude of
striking. The relationshipbetween the dividend its standard error.16

TABLE 3.- DATA ARRANGED BY DECILE AccORDING TO THE VALUE OF D/P

PB - PA a

D
Probability
DIP Standard Z True Mean is Implied
Decile Mean Mean Deviation Value One or More Tax Bracket
1 .0124 .6690 .8054 .411 .341 .4974
2 .0216 .4873 .2080 2.465 .007 .6145
3 .0276 .5447 .1550 2.937 .002 .5915
4 .0328 .6246 .1216 3.087 .001 .5315
5 .0376 .7953 .1064 1.924 .027 .3398
6 .0416 .8679 .0712 1.855 .031 .2334
7 .0452 .9209 .0761 1.210 .113 .1465
8 .0496 .9054 .0691 1.369 .085 .1747
9 .0552 1.0123 .0538 .229 .591 b

10 .0708 1.1755 .0555 3.162 .999b

PB - PA
a Spearman'srank correlation coefficient between DIP and is .9152 which is significant at the 1 per cent level.
b Indeterminate.

yield and the statistic measuring ex-dividend The implied tax rates for the last two deciles
behavior is positive and statistically significant cannot be computed. In both deciles the mar-
at the one per cent level.'4 In fact, with the ket exhibits a preference for dividends over
exception of the first and eighth decile the test capital gains, with the preferencebeing stronger
and in fact statistically significant at the 1 per
The possibility of bias arises in our rank correlation cent level for the 10th decile.'7
13

because of the use of dividends in the denominator of one


of our variables and in the numerator of the other. To The explanation of this preference for divi-
check on the presence of bias, data were collected on a dends over capital gains may be at least par-
random sample of stocks (during our test period) on days tially attributed to our tax structure. While
on which they did not go ex-dividend. Rank correlations
were run on the dividend price ratio versus our statistic and many institutions are indifferent as
to capital
the dividend earnings ratio versus our statistic with the data gains and dividends (tax free institutions such
arranged into 10 groups (deciles), 20 groups, 25 groups, 50
15 The standard deviation of the mean of the ex-dividend
groups and 100 groups. The rank correlation coefficients
ranged from positive to negative with no value significant statistic for the first decile is so high (relative to the stan-
at the 45 per cent level (as we report shortly, Spearman's dard deviation of the mean within other deciles) that we
rank correlation coefficient on the ex-dividend day is always can place little confidence in the ranking of this mean
significant at the 1 per cent level). relative to other means. The extremely high value of the
14 Because deciles are an arbitrary way of grouping data, standard deviation for the first decile is explained by the
we tried a number of other groupings to show that our find- presence of several low dividend stocks in this decile. The
ings were insensitive to the method of grouping used. In first decile contained some stocks with quaiterly dividends
particular, we divided the data into 10, 20, 25, 50, and 100 of a few pennies which experienced ex-dividend price move-
groups. In every case, the relationship between our test ments of several times the amount of the dividend.
6 See footnote 15.
statisdtc and the dividend price ratio was found to be
significant at the 1 per cent level. The relationship between
17
In order to imply a marginal tax rate we would need
our statistic and the dividend earnings ratio is always sig- a structural relationship between the c-apital gains tax rate
nificant at the 5 per cent level and usually significant at the and the ordinary income tax rate for individuals or institu-
1 per cent level. tions who prefer dividends to capital gains.

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MARGINAL STOCKHOLDER TAX RATES 73
as pension funds or educational institutions) cant at the 1 per cent level, adding support to
corporationsactually prefer dividends. For ex- the findings discussed earlier. Furthermore,as
ample, corporations are taxed at a rate of 25 expected, the implied tax bracket declined with
per cent on their capital gains but they only an increase in the firm's payout ratio.
pay a tax on 15 per cent of the income they The close relationshipbetween both measures
receive as dividends from another corporation. of a firm's dividend policy and the implied
Thus, a corporation would pay a lower tax stockholder tax bracket suggest that Miller and
on dividends (7.8 per cent) than it did on Modigliani were right in hypothesizing a "clien-
capital gains (25 per cent). While corporations tele effect." As our results show, firms not only

TABLE 4. DATA ARRANGED BY DECILE ACCORDING TO THE VALUE OF D/E

- P a
PB
D
Probability
DIE Standard Z True Mean is Implied
Decile Mean Mean Deviation Value One or More Tax Bracket
1 .204 .677 .801 .403 .3446 .4883
2 .316 .674 .197 1.655 .0485 .4945
3 .371 .756 .134 1.818 .0344 .3889
4 .409 .730 .124 2.179 .0146 .4254
5 .447 .741 .104 2.486 .0064 .4108
6 .486 .680 .108 2.959 .0015 .4848
7 .533 1.024 .125 .191 .5754 b

8 .594 .896 .092 1.133 .1292 .1889


9 .674 .925 .080 .933 .1762 .0806
10 1.040 .899 .086 1.173 .1210 .2245

a Spearman'srank correlation coefficient between DIE and is 0.7939 which is significant at the 1 per cent level.
D
b Indeterminant.

might account for some of the dividend pref- seem to attract a clientele but they attract a
erence exhibited by the last two deciles, the rational clientele - one which should prefer
authors do not believe that this phenomena is their dividend policy.
widespread enough to account for the extent of
dividend preference. Part of the preference for
Summary
dividends might result from behavioralpatterns
which, while not wholly rational, have become In this paper, we have derived marginal
widely recognized over time. One behavioral stockholder tax brackets by studying the ex-
pattern that could account for part of the pref- dividend behavior of common stocks and have
erence for dividends is the propensity for the shown that these tax brackets are related to a
beneficiary of trust accounts to be restricted or firm's dividend policy. These findings . . ...
to restrict himself to dividend income from the 1. Provide data that is necessary in order to
account. Since capital gains cannot be used as calculate a firm'scost of retained earnings
income, the trust manager would prefer to re- and to test investment models.
tain the right to the dividend. This type of 2. Provide evidence in support of Modi-
behavior along with the tax advantage of divi- gliani's and Miller's clientele effect, sug-
dends for a few types of institutional investors gesting that a change in dividend policy
could account for the dividend preference ex- could cause a costly change in shareholder
hibited by the last two deciles. wealth.
Table 4 contains the same type of data that 3. Illustrate one form of market rationality
is contained in table 3 except that the analysis in that stockholdersin higher tax brackets
has been performed in terms of the firm's pay- show a preference for capital gains over
out ratio. The relationship between our test dividend income relative to those in lower
statistic and the firm's payout ratio is signifi- tax brackets.

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74 THE REVIEW OF ECONOMICS AND STATISTICS
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Industrial Management Review, 9 (Spring, 1968), view, II (May 1961), 179-198.
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