An empirical examination of the effect of dividend taxation on asset pricing and returns in Germany

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An empirical examination of the effect of dividend taxation on asset pricing and returns in Germany A. Murphya,*, C. Schlagb a Department of Finance, Oakland University, Rochester, MI, 48309-4493, USA Department of Finance, University of Frankfurt, D-60054 Frankfurt am Main, Germany Received 13 July 1997; received in revised form 14 August 1997; accepted 14 May 1998

b

Abstract This research finds evidence that required pretax returns on German stocks are unchanged as a result of the enactment of a law in Germany providing shareholders with tax credits for dividends received. In the most recent time interval, higher risk-adjusted pretax returns are discovered on high-yielding German stocks. These findings imply that the effect of the tax credits has been more than offset by other factors.  1999 Elsevier Science Inc. All rights reserved.

The effect of dividend payments on required stock returns has been the source of a long series of debates and empirical tests (Keim, 1985). Research on the U.S. market has uncovered some evidence of a tax effect, where higher returns are required on stocks with higher dividends because dividend income has often been taxed at a higher rate than capital gain income (Litzenberger & Ramaswamy, 1979) and because capital gains can often be deferred for tax purposes through a strategy of buying and holding investments (Miller & Scholes, 1978). Some evidence of a clientele effect has been discovered, whereby the relation between required returns and dividend yields is nonlinear, because investors in different tax situations are attracted to stocks with different dividend yields (Blume, 1980). However, having demonstrated flaws in the research methodologies of these studies and having empirically found no evidence of a long-term relation between dividend yields and pretax returns in their own investigation, Miller and Scholes (1978) have cast doubt on the existence of premium returns being required on higher-yielding stocks, which are preferred by some investors such

* Corresponding author. Tel.: (248) 370-2125. 1044-0283/99/$ – see front matter  1999 Elsevier Science Inc. All rights reserved. PII: S1044-0283(99)00004-6

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as corporations that benefit from the tax laws excluding a large part of U.S. dividend income from corporate income taxation. Most of the more recent research on this subject has focused on the behavior of stock prices on the ex-dividend day. For instance, Poterba and Summers (1984) and Lasfer (1995) found empirical evidence in Great Britain that higher returns have been earned on the ex-dividend date only in periods when dividend income has been effectively taxed at a rate that is higher than the capital gains tax rate, whereas Barclay (1987) uncovered similar evidence for the U.S. However, Stickel (1991) found empirical evidence of significantly higher returns also being earned on the ex-dates of U.S. preferred stocks, which are typically owned by corporate investors that are taxed at lower effective rates on dividend income than on capital gains. Dubofsky (1992) discovered that trading procedures with respect to setting the bid and ask prices on the ex-date, in contrast with taxes, may be responsible for some of the daily return abnormalities that have been found on the ex-date. Eades et al. (1994) found evidence that any simple tax effects can be masked on the ex-date by a complex set of other factors such as transaction costs and arbitrage trading. Bali and Hite (1998) showed that simply the discrete trading of stocks in increments of 1/8 can result in the stock price not falling by the full amount of the dividend. Michaely and Murgia (1995) discovered ex-day returns in Italy to be distorted by investors seeking anonymity from a registration process that takes place on the ex-date. Kato and Loewenstein (1995) found ex-dividend day returns in Japan to be transitory and to be possibly associated with complex trading and microstructure factors unrelated to simple dividend taxation effects. In Hong Kong, where there are no taxes on dividends or capital gains, Frank and Jagannathan (1998) found average prices to fall by less than the dividend on the ex-date because closing transactions tend to occur more often at the bid price on the last cum-dividend date and at the ask price on the ex-dividend date. This research is intended to provide additional evidence of the effect of dividend taxation by investigating the special tax situation in Germany, where laws have been in effect since 1977 that effectively eliminate double taxation of dividends through a provision of dividend tax credits to shareholders for corporate income taxes paid. Although this phenomenon has been previously investigated by Bay (1990), he focused only on the ex-dividend date returns to German stocks, and his findings are subject to the same caveats as other ex-date studies. His findings indicated that German equities on ex-dates earned significantly positive returns, with the returns inclusive of dividend tax credits rising after 1977, but he admitted that banks and brokers faced with low transaction costs should easily be able to arbitrage any actual short-term abnormal return that could be earned on the ex-dividend date. Although Bay (1990) inferred from his results that long-term investors in high (and rising) tax brackets must somehow be determining the returns required on higher-yielding stocks on exdates, he qualified his findings by stating that it was unclear whether trades could actually occur at the prices used in his study, insofar as he ignored ex-date trading procedures and distortions (including how bid and ask prices are set), he used official price quotes that often did not reflect actual trades, and he failed to examine whether the returns were transitory.

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To avoid distortive and transitory ex-day effects, only longer-term returns to German stocks are examined in this research.1 The tax situation in Germany is analyzed in Section 1, the investigative methodology is described in Section 2, the empirical results are explained in Section 3, and the findings are summarized in Section 4. 1. The tax environment in Germany Since 1977, German shareholders receiving dividends from German corporations have been entitled to tax credits equal to the amount of federal income taxes effectively paid by the corporations on the distributed profits (Haegert & Lehleitner, 1985). Nevertheless, the full amount of each investor’s share of the pretax distributed profits (not just the dividend received net of corporate income taxes paid) is treated as taxable income to the investor. Because the top individual tax rate of more than 50% in Germany is greater than the top corporate tax rate of 36% on distributed profits, the tax credit merely pays for a part of the taxes owed on the pretax distributed profit income that must be declared by investors in the highest tax brackets. However, German investors whose dividend income is taxed at lower rates (below 36%) actually receive more usable tax credits than are necessary to make the dividends tax free, so the after-tax yield exceeds the before-tax dividend yield for such investors.2 For German investors in the 36% marginal tax bracket, the dividend tax credits effectively make dividend income tax exempt. Nevertheless, for investors not subject to German taxation, the dividend tax credits are not usable and have no effect on their total return.3 This group includes taxexempt German organizations, foreign investors, and investors who illegally fail to report their investment income.4 Tax-exempt German organizations are not taxed at all on dividend income from German equities, and so they cannot use the dividend tax credits. The dividend income of foreign investors is subject to tax in their own countries, but they cannot use the German dividend tax credits there. Investors who illegally fail to report their investment income for tax purposes not only cannot claim the German dividend tax credits, but also cannot claim a tax credit for the 25% withholding tax that is levied on dividend income in Germany. The nonreporting tax dodgers are therefore effectively taxed at the 25% withholding tax rate, although other investors are normally unaffected by the withholding tax, because they generally receive tax credits or rebates for such taxes paid.5 An illustration of how after-tax yields to investors are affected by the withholding tax, as well as the dividend tax credit, is provided in the Appendix. The relative attractiveness of dividend income is affected by the existence of special rules for taxation of capital gains. In particular, for German individuals, capital gains and losses are reported as normal taxable income only if the assets are held less than 6 months and are not subject to tax otherwise. In addition, although all German corporate investors must treat realized capital gains as normal taxable income (i.e., taxed at a 36% rate for distributed profits and at a 56% rate for retained earnings, regardless of holding period) and although many foreign investors are also taxed on their realized capital gains (albeit at a lower tax rate for long-term capital gains for

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investors in many countries such as the United States), investors may always defer capital gains taxation indefinitely through a buy-and-hold strategy. As a result, a pretax German mark of cash dividend income (gross of withholding taxes) would be preferred over a pretax German mark of capital gain only by German investors that actively trade and by German individuals in lower tax brackets, even after the tax law change in 1977 that effectively eliminated double taxation of dividends. Although survey data reported by Iber (1983) and Monatsberichte der Deutschen Bundesbank (1989a) indicate that German corporations (which are subject to capital gains taxation) have historically owned an average of about 50% of German stocks, with this percentage rising over time (compared with average ownership of approximately 20% for individuals, 10% for tax-exempt entities, and 20% for foreign investors, with each of these percentages falling, falling, and rising, respectively, over time), most German corporations follow a buy-and-hold strategy (Monatsberichte der Deutschen Bundesbank, 1989a) that avoids capital gains taxation (implying that they too may not prefer dividend income, which is positively taxed if retained). Prior to 1977, the same rules with respect to capital gains applied in Germany (with long-term capital gains being tax free for individuals), but dividends were subject to normal income taxation. This situation implies that dividend income would not have been preferred to capital gains prior to 1977 by any investors.6 After the tax change in 1977, the preference for capital gains would have declined for all investors subject to German taxation (although, as previously mentioned, only a minority of German investors would actually prefer dividend income after 1977). According to equilibrium models of asset pricing (Murphy, 1990), if some investors subject to German income taxation optimally held German stocks prior to 1977, the change in the tax rules in 1977 may have reduced the required pretax returns on German stocks that paid dividends.7 However, other variables (including nontax factors) may have affected returns on stocks that pay dividends (for instance, higher average marginal tax rates for investors in German stocks would have reduced the effect of the dividend tax credits).

2. Testing procedure To test the effect of varying dividend tax rules in Germany, it is possible to utilize the Capital Asset Pricing Model (CAPM) framework suggested by Murphy (1990). This framework is especially suitable for Germany because Sauer and Murphy (1992) found risk-return tradeoffs in Germany to be fairly well characterized by Sharpe’s CAPM (Sharpe, 1964) relation [Eq. (1)]: E(Rj) 5 Rf 1 Bj{E(Rm) 2 Rf},

(1)

where R denotes the pretax return on the subscripted asset, italics denote a random variable, E is the expected value operator, j is any risky asset, m is the market portfolio of all risky assets, f is the risk-free asset, and B is the beta of the subscripted asset defined by [Eq. (2)]: Bj 5 Covariance(Rj,Rm)/Variance(Rm),

(2)

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which can be estimated by using the regression Rj 2 Rf 5 aj 1 Bj{Rm 2 Rf} 1 uj,

(3)

where aj is the intercept often called the CAPM alpha, and uj is the regression disturbance. 2.1. Testing framework The Murphy (1984) model suggests regressing CAPM alphas aj for a cross section of German stocks on the respective cross-sectional factors hypothesized to cause the deviations. For purposes of testing the effects of preferential tax treatment of dividend income, this framework mandates regressing the cross-sectional alphas on the respective expected dividend yields on each stock; that is, a 5 c0 1 c1Y 1 v,

(4)

where a is the vector of German stock alphas estimated from Eq. (3), Y is the vector of expected dividend yields on German stocks, v is the regression error term, and the c terms are parameters to be estimated. According to the Murphy (1984) model, which shows that all investors are at the margin with respect to the purchase or sale of additional increments of each asset, the c1 parameter measures the weighted-average return required by investors for stocks with higher dividend income, where the weights are determined by the amount of money invested into stocks by each investor. The c1 parameter should be significantly positive when the average investor in German stocks had to pay higher taxes on dividend income than on capital gains, which might be the case in periods prior to the existence of dividend tax credits in 1977. In post-1977 periods, the c1 parameter might be significantly lower than in pre1977 time periods because of the existence of dividend tax credits after that year, and the parameter might even be negative if the average investor in German stocks was subject to a tax rate below 36%. On the other hand, German investors exempt from taxation would mitigate any positive or negative effect on the c1 parameter by driving it toward zero (because they would be indifferent between dividend income and capital gains). However, as hypothesized by Bay (1990), the existence of dividend tax credits after 1977 may have motivated German investors in higher tax brackets to increase their holdings of German equities and to reduce the amount of dividend income that they illegally failed to report. The resulting higher average tax rate on German dividend income would increase the average premium return required on stocks with higher dividend yields and may have partly, fully, or even more than offset the effect of the dividend tax credits (implying that the c1 parameter after 1977 could decrease less, stay the same, or even increase, respectively). Similarly, an increase in the holdings of German equities by foreign investors subject to higher tax rates on dividend income (and not eligible for the dividend tax credits) would have the effect of increasing the required returns for stocks with higher dividend yields. Because security alphas can be caused by factors other than tax considerations, Eq.

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(4) must be expanded to allow for additional independent variables (Murphy, 1990). In particular, prior studies of the U.S. market indicate premium returns being required on stocks of small firms and on stocks that pay no dividends (Keim, 1985). Higher returns might be required on non-dividend-paying stocks because some investors are restricted by institutional rules and prejudices from holding stocks that do not pay dividends (Black, 1976). In addition, as hypothesized by Shefrin and Statman (1984), investors may prefer stocks that pay dividends so as to mitigate feelings of regret (the dividends provide a psychological offset to potential future capital losses) and enhance self-control over spending (the dividends provide investors with cash flow while maintaining the discipline of not dipping into capital). Moreover, if investors interpret dividends to be an indicator of the financial health of a company (Bernheim & Wantz, 1995), as may be especially applicable in Germany, where a low level of accounting and information disclosure (relative to the United States) may cause investors to rely more on dividends than earnings reports to evaluate German stocks (Amihud & Murgia, 1997), the existence of dividends may reduce investor uncertainty about stocks (Shefrin & Statman, 1984). Investors may require higher returns on the stocks of small firms to compensate investors for the existence of higher transaction costs on such firms (Stoll & Whaley, 1983). In addition, higher required returns on stocks of small firms may reflect the greater uncertainty caused by a lack of information and research about the companies (Arbel et al., 1983). To allow for these additional effects on required returns and thereby prevent model misspecification from leading to a spurious relation between alphas and dividend yields (Keim, 1985), the regression can be run as follows: a 5 c0 1 c1Y 1 c2D 1 c3S 1 v,

(5)

where D is a dummy variable with a value of one for stocks that do not pay a dividend (and zero otherwise), and S is the aggregate market value of the firm’s equity. 2.2. Statistical methodology To estimate the alphas in regression Eq. (3) that are to be used as the dependent variable in regression Eq. (5), a 6-year time series of logs of one plus the monthly excess returns above the risk-free rate on each stock is regressed on the monthly time-series logs of one plus the excess returns on a proxy for the market portfolio for German investors, where logged excess return relatives are used to adjust for the existence of different holding periods among investors (Sauer & Murphy, 1992). However, because the market portfolio for German investors cannot be precisely specified, the independent variable in regression Eq. (3) is measured with error, and the parameter estimates from the regression are biased (Judge et al., 1982). To obtain unbiased alpha estimates, an instrumental variables (IV) estimator is used in the firststage regression (Johnston, 1984), with the instrument being an alternative proxy for the market portfolio.8 The three cross-sectional independent variables in the second-stage regressions of Eq. (5) are estimated by using data from the most recent month prior to the beginning

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of the 6-year time interval used to estimate the alphas with regression Eq. (3). Y is computed as the log of one plus the most recent annual dividend yield on each stock (measured as the total dividend, net of corporate income taxes, paid out on the stock over the year preceding the 6-year time interval used to estimate the stock’s alpha, divided by the price at the end of the month preceding the time interval used to estimate the alphas), D is determined by the existence of any dividend payment on each stock in the year preceding the time interval used to estimate alphas, and S is calculated as the aggregate market value of all shares of the stock in the month prior to the time interval used to estimate the alphas. Because the dividend yield in the most recent period only acts as a proxy for the actual dividend yield expected by investors in the future, the regression in Eq. (5) is subject to the problem of error in variables. As a result, an IV estimator should also be employed in the second-stage regression (Kmenta, 1984). The instrument is specified to be the log of one plus the annual dividend yield on each stock lagged 1 month before the time interval used to estimate the alphas (i.e., the annual dividend paid on the stock over the period between 13 months and 1 month before the interval used to estimate the alphas, divided by the stock’s price 1 month before the 6-year time interval used to estimate the alphas). In addition, because of the possibility of heteroskedasticity in the second-stage estimation in Eq. (5), a Generalized Least Squares (GLS) regression can be used to ensure unbiased standard errors and test statistics (Mankiw & Shapiro, 1986).9 The GLS covariance matrix is estimated from the covariance between the residual asset returns computed in the first-stage regressions in Eq. (3), as in Sauer and Murphy (1992). Covariance terms for which the correlation coefficient estimates are insignificantly different from 0 at the 5% level are set equal to 0 to make the covariance matrix nonsingular (Gibbons, 1982). 2.3. Data Data for the test are available from the University of Karlsruhe Capital Market Data Base (Sauer & Murphy, 1992). Total pretax monthly returns are obtained on all German stocks actively traded on the Frankfurt Stock Exchange (the largest stock exchange in Germany) over the interval 1968–1991. Pretax returns are measured as capital gains plus dividend income, where dividends are measured gross of withholding taxes but net of corporate income taxes, and so the dividend income included in returns does not include any dividend tax credits for corporate income taxes paid. This method of reporting dividend income is standard for German stocks and represents the effective pretax yield available to foreign investors who receive tax credits only for German withholding taxes paid. These pretax returns on German stocks are also equal to the after-tax returns for tax-exempt investors and for German investors in the same 36% tax bracket as the dividend-paying corporation. However, these pretax returns are less than the after-tax returns for investors subject to tax rates less than 36% and are greater than the after-tax returns for tax dodgers and investors subject to tax rates greater than 36%. To be able to study time-series changes in the relation between dividends and

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returns, the sample can be decomposed into four equal 6-year intervals between 1968 and 1991, with all stocks in existence over each entire 6-year interval being included in the study. This sample includes 176 stocks in the 1968–1973 interval, 184 stocks in the 1974–1979 interval, 250 stocks in the 1980–1985 interval, and 259 stocks in the 1986–1991 interval, with average dividend yields of 3.24%, 3.20%, 2.72%, and 2.15%, respectively.10 The first interval exists before the tax change, the second interval is a transition time period that is long enough to allow for any anticipatory or lagged effects, and the last two intervals are time periods that permit examination of the consistency of any post event result. Such a sample division avoids the greater noise that exists with finer time intervals and reduces the chance of an artificial relation being found between dividend yields and returns that a Fama and MacBeth (1973) monthly time-series regression might cause, owing to the positive association between dividend yields and interest rates (Fama and French, 1988). For purposes of computing returns in excess of the risk-free rate as in Eq. (3), the 1-month interbank deposit rate on German marks is obtained from the Karlsruhe Data Base (because short-term government T-bills do not exist in Germany). To compute the return on the market portfolio proxy in Eq. (3), a 50-50 stock-bond weighting can be specified from indexes obtained from the same data base. The total pretax return on stocks (capital gains plus dividends gross of withholding taxes) are measured by using the Deutscher Aktien-Forschungsindex (DAFOX), which is computed as the market-weighted average return on all stocks traded on the Frankfurt Exchange (Goeppl & Schuetz, 1993). Total pretax returns on German bonds (interest plus capital gains) are measured by using the Rentenindex, which is computed as the average return on a portfolio of 30 German government bonds (whose composition is adjusted periodically to maintain a stable duration). For the market portfolio instrument (necessary in addition to the 50-50 proxy for the IV estimator), total pretax returns (capital gains plus dividends gross of withholding taxes) on a 100% stock index are measured by using the Deutscher Aktienindex (DAX), which is computed as the market-weighted average return of a widely followed portfolio of 30 German stocks. Use of domestic market portfolios for testing purposes can be justified for theoretical and empirical reasons as explained by Sauer and Murphy (1992). In particular, given the existence of capital controls and market segmentation in Germany over a part of the sample interval (Baille et al., 1983) and given the possibility of domestic multinational corporations providing a large amount of international diversification (Agmon and Lessard, 1977), required returns might be more closely dependent on the return covariance with a domestic German index than with an international index, as has been shown theoretically (Stulz, 1981) and empirically (Solnik, 1974). In addition, the very existence of dividend tax credits only for German investors would tend to increase market segmentation by making German stocks relatively more attractive to German investors (Wood, 1997). Regardless, in such an environment, any optimal international portfolio holdings may vary from investor to investor, and tests can examine only risk-return relations for a representative investor (Murphy, 1990). Because more than 80% of German stocks have typically been held by German investors (George & Giddy, 1983), because individual German investors have generally held less than 10%

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Table 1 Relation between CAPM alphas and dividend yields in Germanya: a 5 c0 1 c1Y 1 c2D 1 c3S 1 v Parameter c0 (s.e.) c1 (s.e.) c2 (s.e.) c3 (s.e.)

1968–1973

1974–1979

1980–1985

1986–1991

0.0286 (0.0107) 20.1577 (0.1401) 20.0038 (0.0064) 20.0016* (0.0006)

20.0040 (0.0120) 0.0736 (0.0951) 0.0052 (0.0060) 20.0002 (0.0008)

20.0002 (0.0120) 20.0364 (0.2597) 20.0017 (0.0090) 20.0001 (0.0008)

20.0019 (0.0053) 0.3951* (0.0840) 0.0100* (0.0027) 20.0003 (0.0003)

Note: * Statistically significant from 0 at the 0.05 level [standard errors (s.e.) are reported in parentheses below the parameter estimates]. a a is the vector of stock alphas, Y is the vector of stock dividend yields, D is a dummy variable with a value of 1 for stocks that do not pay dividends, and S is a vector of the aggregate market value of each stock. The alphas are estimated by using an instrumental variables eliminator, whereas the c parameters are estimated by using a GLS instrumental variables eliminator (with the covariance matrix being estimated from the residuals of the first-stage regression employed to estimate the alphas).

of total German foreign holdings (Monatsberichte der Deutschen Bundesbank, 1989b), and because stock market indexes are more heavily weighted toward multinational stocks than a total domestic portfolio would be, a domestic index seems to be a good indication of the portfolio of a representative investor in German stocks. The use of an IV estimator in the test enables the proxy to be valid for an even wider range of representative investors whose portfolios are highly correlated with the domestic index (Murphy, 1990).

3. Results The results of regression Eq. (5) are reported in Table 1. After controlling for clientele and size effects, we did not find CAPM alphas to be statistically related to dividend yields in the first three intervals. In the final interval (1986–1991), however, the relation between pretax returns and dividend yields became positive and statistically significant from zero.11 These results provide no evidence of the tax law change having an effect on required pretax returns. In particular, in the first full interval after the tax law change, there was no significant change in the premium required for dividend yield, and there was a significant effect opposite that expected in the second full interval after the granting of tax credits for dividend income.12 3.1. Evidence of tax effects The findings seem to imply that dividend income was equally attractive before the tax law change and after it. This situation is consistent with the hypothesis that the 1977 tax law caused a change in the average marginal tax rate of German stock

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investors, as more investors in higher tax brackets became more willing to purchase (and pay taxes on) dividend-paying stocks.13 After 1985, the trend toward higher marginal tax brackets for German stock investors might have resulted in the significantly higher pretax premium being required for stocks paying dividends. In particular, the finding of higher pretax returns for stocks with higher dividend yields is consistent with a hypothesis that the average investor in German stocks has a marginal tax rate in excess of 36% and engages in strategies that avoid capital gains tax (by holding stocks for at least 6 months for individual investors and engaging in even longer buy-and-hold strategies for corporate investors). Such strategies make dividend income relatively unattractive and cause the average investor to require higher premium returns on stocks that earn higher yields in that form. In addition, the empirical findings are also consistent with the proportion of foreigners investing in Germany increasing over time (Monatesberichte der Deutschen Bundesbank, 1989b), which may have occurred because of the reduction in capital controls (Baille et al., 1983). If the foreign investors were subject to a relatively higher tax rate on dividend income than on capital gain income (as was the case, for instance, not only for U.S. investors subject to tax, especially those who deferred their capital gains taxes on stocks by not selling them, but also for tax-exempt U.S. investors who are not rebated the full amount of the German withholding tax as explained in footnote 5), the foreign investors might contribute to the situation where dividend income became more unattractive after 1985 for the average investor in German stocks.14 3.2. Evidence of other effects on German stock returns The results in Table 1 also provide some indication that higher returns existed in the 1986–1991 time interval on German stocks that do not pay dividends. As a result of artificial prejudices, behavioral phenomena, and information uncertainty, some German and foreign investors may require higher returns on stocks that do not pay dividends (Shefrin & Statman, 1984). In addition, Table 1 reveals evidence of a size effect in German stocks for the 1968–1973 time interval that is similar to that found in the United States (as indicated by the negative relation between returns and size).15 Investors may have required a higher return on stocks of small firms over the 1968–1973 interval at least partly because of the higher transaction and information costs associated with investing in such stocks (Brennan & Subrahmanyam, 1996). One possible reason for the lack of a significant relation between returns and size in the more recent time intervals, however, is that the transaction and information cost effects may be offset by a voting power effect. In particular, the shares of smaller firms in Germany may have greater value for voting and control purposes than do the shares of larger firms (DeAngelo & DeAngelo, 1985). The voting rights of smaller firm shares might be more valuable than those for larger firms because smaller firms are more likely to be taken over in Germany (Iber, 1983), owing not only to the larger amount of capital necessary to acquire a larger company, but also to stronger legal takeover defenses and to the fact that many larger German firms are already controlled by German commercial banks

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through their ownership of a large number of shares and through their right to vote even more shares through their positions as custodial brokers (Whitney, 1994).16 4. Conclusions This research provides further evidence of the existence of a dividend yield tax effect in an important foreign country environment and casts an additional perspective on the complex structure of dividend yield effects. In particular, pretax returns on German stocks are found to be unchanged as a result of the existence of tax credits being provided to domestic investors for dividend income received. In fact, pretax returns are discovered to be positively related to dividend yields in the most recent time interval, possibly because of increased foreign investment in German equities (because foreign investors do not benefit from the dividend tax credits and pay lower taxes on capital gains) and increased equity investments by German individuals in higher tax brackets (in excess of the 36% rate necessary to make capital gain income more attractive than dividend income). Thus, the straightforward tax effects of dividend yields appear to be swamped in importance by a complex function of other factors, such as changing stock holdings for investors in different tax situations. If this structure of returns continues into the future, the findings of this study have important implications for specific investors. In particular, German investors who are in lower tax brackets (especially below 36%) should focus more on German stocks with higher dividend yields because higher pretax returns are found on such stocks, even though the after-tax returns on such stocks are higher than the pretax returns for such investors.17 On the other hand, German investors in higher tax brackets, as well as foreign investors, should concentrate more on German stocks that pay no dividends because higher pretax returns are found on such stocks, even though the after-tax returns can equal the pretax returns for buy-and-hold investors.18 Acknowledgments This paper was presented at the 1994 Eastern Finance Association meeting and benefitted from the useful comments received there. The especially helpful suggestions of Zoltan Sabov and an anonymous reviewer at Global Finance are also gratefully acknowledged. Appendix: The effect of the withholding tax and dividend tax credits on after-tax yields The mechanics of the withholding and dividend tax credits are similar to those for Italy, as described by Michaely and Murgia (1995), except that the rates are different. For instance, if DM10 in pretax earnings per share are to be distributed to shareholders, corporate taxes take 36% or DM3.60, so the dividend to shareholders is DM6.40. A further 25% withholding tax is levied on the DM6.40 dividend (0.25 3 DM6.40 5 DM1.60) before payment to the shareholders (resulting in only DM6.40 2 DM1.60 5

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DM4.80 in cash dividends actually being paid to the investors). For the shareholder, the full DM10 in pretax distributed corporate profits would be taxable even though the dividend is only DM6.40 (and only DM4.80 is received in cash). However, German shareholders would also receive tax credits of DM3.60 1 DM1.60 5 DM5.20 for the income taxes and withholding taxes, respectively, paid by the corporation on the gross income distributed. If the shareholder were in the 30% tax bracket, the investor would owe DM3.00 in taxes on the DM10 in gross income received. After using DM3.00 of the DM5.20 in tax credits to pay this tax liability, such an investor would still have DM2.20 left in tax credits that could be used to pay taxes owed on other income. Such an investor therefore effectively receives the DM4.80 in cash dividends tax free and also receives DM2.20 in additional tax credits that can be used. Thus, a German shareholder in the 30% tax bracket receives an effective DM4.80 1 DM2.20 5 DM7.00 tax-free dividend, which is even higher than the DM6.40 declared dividend. On the other hand, with the same example, investors who illegally fail to report their dividend income would receive only the DM4.80 of the dividend paid out in cash (regardless of their tax bracket) because they cannot receive the tax credit without declaring the dividend income. Prior to 1977, there was a greater incentive to conduct illegal tax dodges because only the withholding tax credit was lost by failing to report dividend income. Although most of the incentive to dodge dividend taxation was removed after 1977 for German investors, many may have continued not to report dividend income, because they wanted to keep their stockholdings hidden from the significant wealth tax in Germany that is levied at a rate of 0.6% on the market value of an investor’s holdings (this wealth tax almost exceeds the dividend withholding tax on the average German stock). Habit, privacy (especially with respect to hiding assets from potential heirs and divorced partners), a desire to evade inheritance taxes, fear of adversary future tax changes, and a desire to avoid tax on interest income for shifting portfolio allocations also may have contributed to a continued use of foreign secret bank accounts (especially in Liechtenstein) whose stock holdings and dividend income generally would not be reported (Boelke & Schreiber, 1997). Foreign investors in German stocks are not entitled to the dividend tax credit, but they generally can receive a tax credit or rebate for any withholding taxes paid if the dividend income is declared. As a result, foreign investors continued to have the same incentive not to report their dividend income after 1977 to the extent that the tax rate on dividend income in their own country exceeded the withholding tax for which they would receive credit if they did report. Notes 1. Although an investigation of the relation between monthly returns and dividends in Germany was previously conducted by Koenig (1990), his results are suspect for various econometric reasons. In particular, his regressions of stock returns on dividend yields may have been misspecified insofar as relevant variables (such as corporate size and a dummy variable for non-dividend-paying stocks that have been found to affect stock returns) were not included as

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independent variables (Keim, 1985). As a result, the regression may have attributed premium returns to the coefficient for stocks’ dividend yields that were actually only proxying for omitted variables (Rao, 1971). In addition, Koenig’s only allowance for risk was to include in the regression an independent variable in the form of a beta parameter estimate, which was computed as the regression coefficient from a separate regression of individual stock returns on the returns of a proxy for the market portfolio of all assets (Koenig, 1990). This beta parameter estimate was biased because he did not address the problem of an unobservable market portfolio (Judge et al., 1982). Possibly as a result of such econometric problems, his results, which included a finding of higher positive returns being earned on high-yielding stocks before 1977 than after 1977, indicated an unexplainable negative relation between stock returns and beta risk that he himself labeled as “not plausible.” 2. The tax rate is lower than 36% for individuals with gross income under DM65,000, or about $40,000 (whereas the highest individual tax bracket, which has varied between 53% and 56%, applies to gross income over DM120,000). However, because German individuals could exclude the first DM700 in distributed profits (raised to DM6100 after 1993) from taxable income, investors subject to a high tax rate (above 36%) can be treated as tax-exempt investors for that part of dividend income. For instance, with dividend yields averaging under 3% in Germany, investors could own more than $10,000 worth of normal dividend-paying stocks before 1993 and not have taxable dividend income. 3. It is actually possible for investors not subject to German taxation to benefit from the dividend tax credit by selling the dividend part of stock returns to an investor or intermediary who does benefit from the dividend tax credit. A typical scheme could involve an intermediary subject to German taxation (such as a German bank) buying up stocks and selling forward contracts on the stocks to investors not subject to German taxation. Investors not subject to German taxation may also buy futures contracts on stocks or create synthetic forward contracts by buying calls and selling puts (Angel et al., 1997). The seller of the forward contract can therefore receive the dividends and dividend tax credits, whereas the investor not subject to German taxation receives the capital gain. Because the tax benefits thus obtained might be reflected in the price of the forward contract, investors not subject to German taxation might obtain higher returns through the purchase of such forward contracts than by buying the stocks. Although this strategy might result in higher transaction costs and capital gains taxes compared with a strategy of buying and holding the stock, such costs could be reduced through the use of long-term forward contracts. 4. Because most investments in Europe are held in unregistered bearer form through anonymous accounts at banks, which are allowed by law to provide secrecy from tax authorities, it is possible to effectively avoid taxation of all investment income (dividends, interest, and capital gains) by simply failing to report the income (Boelke & Scheirber, 1997). Tax compliance by European investors is in fact extremely low. For instance, only 2% of taxable investment

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income is reported by Italian individuals (Michaely & Murgia, 1995). An estimated 400 billion marks in tax revenue (about half of taxes actually collected) are lost by the German government each year owing to illegal tax dodges (Auf einen Blick, 1998). 5. As explained by Schmedel (1997), foreign investors receive a part of the witholding tax back through application for a refund from the German government if their country has a tax treaty with Germany (as the United States does, entitling U.S. investors to a refund of 15% of the 25% withholding tax). Compensation for the remaining amount may be obtained in the form of a tax credit in the investors’ own countries (according to current U.S. tax law, in addition to receiving a tax credit for the net 25% 2 15% 5 10% withholding tax paid, U.S. investors actually receive an extra tax credit equal to 5.88% of the gross dividends from German stocks, which effectively results in them receiving a small part of the dividend tax credit). However, the tax credit cannot be used by foreign tax-exempt investors (or investors who take positions on German stocks through IRAs or corporate retirement accounts), and such investors are effectively taxed like tax dodgers (unless their country has a tax treaty with Germany, in which case they are effectively subject to only the part of the withholding tax that is not rebated by Germany, such as 10% for U.S. taxexempt investors). 6. It should be mentioned, however, that various legal tax dodges exist that make dividend income less unattractive (Der Spiegel, 1992b). For instance, because dividend payments are usually made annually, it has always been possible to obtain tax-exempt income by holding stocks for more than 6 months but selling before a dividend payment date (Der Spiegel, 1992a). This legal tax dodge, which can also be used to obtain tax-exempt income from bonds that typically pay interest annually, is mitigated by the existence of transaction costs on the necessary trades (which, in Germany, include an average 1% commission, 0.25% in transfer taxes, and the bid-ask spread, although bank dealers and brokers are able to avoid most of these costs). The strategy of selling before an expayment date may also be pursued through German mutual funds, which generally pay dividends annually, although the traditional front-end loads in Germany, typically equaling 5% for stock funds, 3% for bond funds, and 1% for money market funds (Geld & Boerse, 1992), would reduce the attractiveness of such a strategy. It should also be mentioned that legal tax dodges exist for other investments in Germany, such as real estate (Der Spiegel, 1997) and insurance (Wendling, 1988), which have write-off and tax deferral benefits similar to those that were available on such investments in the United States in the 1970s, but there are much higher transaction costs associated with trading such assets. 7. For instance, in a recent cross-sectional study, Sauer and Murphy (1992) found evidence that risk-adjusted pretax returns on German stocks were significantly lower than the pretax returns on money market investments in the 1980s. On the other hand, they did not find such a result for pre-1980 periods. The authors

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8.

9. 10.

11.

12.

13.

14.

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hypothesized that dividend tax benefits available after 1977 may have been the cause. As shown by Murphy (1990), the regression model in Eq. (5) may be tested on the average portfolio of any group of investors, but the IV estimation methodology generalizes the examination to a broader group of investors with similar portfolios. With an IV estimator, the GLS adjustment affects only the standard errors, not the parameter estimates (Fomby et al., 1984). The sample excludes a small number of stocks of firms that were either liquidated or acquired by other firms within a time interval, as well as any new stocks that began trading during a time interval. Although the exclusion of such stocks could create a problem of sample bias, Sauer and Murphy (1992) found that inclusion of such stocks into CAPM tests has little effect except to increase the standard errors of the estimators (i.e., excluded liquidated firms with large negative returns are offset by excluded firms such as acquistion targets with large positive returns). Similar results were obtained for the most recent time interval when the regression was run with only one independent variable as in Eq. (4). Use of the Litzenberger and Ramaswamy (1979) time-series regression testing framework (with weighted least squares) also revealed a significant positive coefficient for the dividend variable in the 1986–1991 interval and insignificance in the other three time intervals. In addition, simple Ordinary Least Squares market model alphas for five groups of stocks ranked according to the size of the dividend yield were estimated (by using the 50-50 market portfolio), and the alpha intercepts were found to be uniformly increasing with the dividend yield in the 1986–1991 interval. The significantly positive relation between stock returns and dividend yields found in the 1986–1991 interval was robust to the fact that, during this interval, there were rising stock prices and interest rates, both of which are often associated with relatively lower returns on higher dividend-yielding stocks because investors are attracted to investments in less-defensive equities and higheryielding bonds in such an environment. This hypothesis is also consistent with the results reported by Bay (1990), who found that the marginal tax rate implied in stock returns on ex-dividend dates increased after 1977. In particular, Bay (1990) found that, although ex-date pretax returns did not increase after 1977, they did increase significantly when tax credits were taken into consideration (implying that investors required higher after-tax returns after 1977 because they were in higher tax brackets). Wood (1997) showed theoretically that, even when dividend tax credits are unavailable to foreign investors, returns should be related to the tax preferences and risk of any international portfolio investors participating in the market. To test this hypothesis, a regression was run on the post-1985 data specifying the proxy to be an average portfolio for a group of representative international investors who invest in Germany and the instrument to be a representative

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15.

16.

17.

18.

portfolio for domestic German investors who invest internationally. In particular, the test was conducted by using the pretax German stock returns translated into U.S. dollars (employing Dollar-Mark exchange rates available from the Karlsruhe data base), by using U.S. T-bill rates reported in Ibbotson & Associates (1992) as the risk-free rates, by using the pretax total dollar returns (capital gains plus dividend income) on the Morgan Stanley World Index as the market portfolio proxy (obtained from Capital International Perspective), and by using as the market instrument a portfolio consisting of equal investments in the Morgan Stanley World Index and the Rentenindex (where the total pretax returns on the Rentenindex are translated into dollar returns employing the Karlsruhe data base exchange rates). The results (not shown) indicated the size and sign of the parameter estimates to be similar to those found by using German currency returns and German market indexes for the same time interval (except that the c3 estimate was significantly below 0). These findings are consistent with the hypothesis that foreign investors may be contributing to the higher return on German stocks with higher dividend yields (the results are also consistent with a hypothesis that German investors who are internationally diversified are also contributing to the higher returns, possibly because they are mostly individuals in higher tax brackets). These results are obtained despite the existence of multicollinearity in the regression. Collinearity between the size and dividend variables exists because small German firms in the sample were found to be more likely than large firms to pay either no dividend or a high dividend, similar to the tendency in the United States (Keim, 1985). As mentioned in note 14, higher returns were found for smaller stocks in the most recent time interval when international portfolios were used as the market proxy and instrument. The reason for this contrary finding may be that, for foreign investors, the transaction and information cost effects more than offset the voting power effect because foreign investors tend to be portfolio investors less interested in acquisition and control. German corporations actively trading German stocks might also prefer highyielding stocks, because they would receive the dividend tax credits but would have to pay taxes on any capital gains on stocks that they sell. As indicated by Bay (1990), because German corporations may deduct any capital losses that occur on the ex-dividend dates, a tax-trading strategy of buying before the exdividend date and selling on the ex-date may generate abnormally high aftertax returns (although transaction costs would reduce the size of these returns). The finding of this study that relative returns on stocks with different dividend yields are unchanged as a result of the dividend tax credits is consistent with the findings of Haegert and Lehleitner (1985) and Behm and Zimmermann (1993) that dividend payout ratios of German corporations did not increase as a result of the 1977 tax law change. In particular, German companies may have hypothesized that, on average, the advantage of the 1977 tax law change to dividend-reporting shareholders would be offset by the disadvantages to foreign

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