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This paper analyzes the ex-dividend day stock price behavior in the Chinese stock market. This market allows to examine the impact of tax effects while keeping any microstructure factors constant. The findings from non-taxable stocks show that their price, on the ex-dividend day, falls by an amount that is not statistically different from the dividend. For the taxable sample, stock prices of small dividend yield stocks fall proportionally to the dividend paid. For the large dividend yield stocks, the price adjustment depends on the effective tax rate on dividend income. The overall findings are consistent with the tax hypothesis.

Finance theory predicts that, in perfect capital markets, stock prices on the ex-dividend day (adjusted for any market-related influence) should fall by an amount that equals the dividend paid. Yet, several studies show that stock prices decrease by an amount that is smaller than the dividend. Many studies attribute this finding to tax effects, that is, to the higher tax rate applicable to income from dividends relative to capital gains. Other studies disagree with this tax-related explanation and attribute the finding to other factors, such as the trading and microstructure characteristics of capital markets. Recently, some studies have attempted to shed light on this issue by studying the ex-dividend day stock price behavior in environments where dividends are not taxed. While this is indeed a good approach, a problem may arise in interpreting the empirical findings in cases where microstructure effects are also present. In this paper, the ex-dividend day price behavior is examined in an environment where the microstructure effects are neutralized. We have chosen the Chinese stock market, where cash dividends could be either taxable or non-taxable, depending on their magnitude relative to the annual interest which could have been earned on an amount equaling the face value of the corresponding stocks. Thus, this study neutralizes the effect of other potential factors, and focuses on the tax effect on stock price behavior on the ex-dividend day. Consistent with the tax hypothesis, the empirical findings for non-taxable stocks show that their prices, on the ex-dividend day, fall by an amount that is not statistically different from the dividend paid. For the taxable sample, the empirical findings vary according to the dividend yield and the effective tax rate on dividends. That is, assuming an effective tax rate on dividend income of 20%, for small dividend yield stocks, ex-dividend day prices drop by an amount that is not significantly different from the tax-adjusted dividend at the 0.05 level. In contrast, high dividend yield stocks experience a price drop that (in statistical terms) is larger than the tax-adjusted dividend. However, when a more realistic effective tax rate, below the statutory 20%, is applied in the analysis (10%, 5% or even 0%), the statistical significance of the difference between the stock price drop and its corresponding theoretical value, in general, disappears. The findings from the non-taxable sample are consistent with the traditional Elton and Gruber (1970) tax hypothesis. When the effective tax rates fall closer to 0%, the findings from the taxable sample are also consistent with the tax hypothesis and they are in line with the findings of Green and Rydqvist (1999) that apply in a similar tax environment, which favors dividends (coupon interest) relative to capital gains. Section 2 presents the most relevant prior research. Section 3 describes the institutional environment of Chinese stock market. Section 4 discusses the methodology and Section 5 explains the data. Section 6 presents the empirical findings and Section 7 contains the conclusions.

This paper analyzes empirically the ex-dividend day stock price behavior in the Chinese stock market. The Chinese market allows to examine the impact of tax effects while keeping any microstructure effects constant. This is possible because in the Chinese environment the dividends could be either taxable or non-taxable for individual investors, depending on their magnitude relative to the one year interest income corresponding to the face value of the associated stock. In addition, there is a preferential tax treatment for cash dividends relative to capital gains for those securities firms and private companies that cannot offset capital gains with capital losses. Consistent with the tax hypothesis, the empirical findings for non-taxable stocks show that, in general, their prices on the ex-dividend day fall by an amount that is not statistically different from the dividend paid, regardless of the dividend yield. For the taxable sample, however, the empirical findings vary according to the effective tax rate assumed on dividend income. In particular, as tax rates move from the statutory 20% to a more realistic effective tax rate (10%, 5%, and 0%), the drop in ex-dividend day prices moves closer to an amount that equals the tax-adjusted dividend. The findings on taxable stocks may reflect the differential tax status of taxable individual investors, securities firms, and private companies. Since we cannot possibly identify the exact tax rates of each participant in the market at any given trading moment, we choose to use multiple scenarios of tax rates between 0% to 20%. At one extreme, we may consider 0% effective tax rate for individual investors and for securities firms and private companies that can sufficiently offset capital gains with capital losses. In this case all investors are indifferent to dividends versus capital gains, thus, leading to a decline in stock prices on the ex-dividend day by an amount that equals the dividend paid. The derived findings with assumed effective tax rate of 0% are consistent with the tax hypothesis. At the other extreme, we may consider: i) 20% as the effective tax rate for individual investors, and ii) that securities firms and private companies have more capital gains than capital losses. In this tax environment, individual investors prefer capital gains, suggesting that stock prices on the ex-dividend day drop by an amount that is smaller than the dividend paid. In contrast, securities firms and private companies prefer cash dividends over capital gains, suggesting that the corresponding stock price decline is larger than the dividend paid. Since observed stock prices reflect the interaction of all investors weighted by their relative magnitude, the equilibrium prices will be a weighted average of the tax-adjusted prices of each group. The reported results in Table 2 and Table 3 for the taxable sample are consistent with the existence of a group of investors (securities firms and private companies) which dominates individual investors, thus, resulting in a stock price decline (on the ex-dividend day) higher than the dividend paid, consistent with the arguments of Green and Rydqvist (1999). The overall implication of this study is that the stock price behavior on the ex-dividend day observed in China is consistent with the tax explanation. Although microstructure effects may be important in explaining the ex-dividend day stock price behavior in some capital markets, the findings from the Chinese stock markets (where the microstructure effects are neutralized) cannot be attributed to such factors.