Lectures Notes Financial markets first semester, Study notes of Economics

Download Lectures Notes Financial markets first semester and more Study notes Economics in PDF only on Docsity! Dividend Capture and Tax Clienteles While many investors have a tax preference for share repurchases rather than dividends, the strength of that preference depends on the difference between the dividend tax rate and the capital gains tax rate that they face. The Effective Dividend Tax Rate Consider an investor who buys a stock today just before it goes ex-dividend, and sells the stock just after.14 By doing so, the investor will qualify for, and capture, the dividend. If the stock pays a dividend of amount Div, and the investor’s dividend tax rate is td , then her after-tax cash flow from the dividend is Div(1 - td ). In addition, because the price just before the stock goes ex-dividend, Pcum , exceeds the price just after, Pex, the investor will expect to incur a capital loss on her trade. If her tax rate on capital gains is tg , her after-tax loss is (Pcum - Pex)(1 - tg). The investor earns a profit by trading to capture the dividend if the after-tax dividend exceeds the after-tax capital loss. Conversely, if the after-tax capital loss exceeds the after-tax dividend, the investor benefits by selling the stock just before it goes ex-dividend and buying it afterward, thereby avoiding the dividend. In other words, there is an arbitrage opportunity unless the price drop and dividend are equal after taxes: The effective dividend tax rate t*d measures the additional tax paid by the investor per dollar of after- tax capital gains income that is instead received as a dividend. Tax Differences across Investors The effective dividend tax rate for an investor depends on the tax rates the investor faces on dividends and capital gains. These differ across investors for multiple reasons: • Income level: different levels of income fall into different tax brackets/rates. • Investment Horizon: Capital gains on stocks held one year or less, and dividends on stocks held for less than 61 days, are taxed at higher ordinary income tax rates. Long-term investors can defer the payment of capital gains taxes. • Tax Jurisdiction: U.S. investors are subject to state taxes that differ by state.