The Effects of Dividend Taxes on Equity Prices: a Re-examination of the 1997 UK Tax Reform

Stephen R. Bond (Nuffield College, Oxford, Institute for Fiscal Studies and Oxford University Centre for Business Taxation)
Michael P. Devereux (Oxford University Centre for Business Taxation)
Alexander Klemm (Institute for Fiscal Studies and University College London)

This paper re-examines the extent to which personal taxes on dividends are capitalised into the equity prices of domestic firms, using data from around the time of the 1997 UK dividend tax reform, which removed a significant tax credit for an important group of investors: UK pension funds. The tax-adjusted capital asset pricing model suggests that the impact should depend on an average of dividend tax rates across all investors, and that UK pension funds should reduce their holdings of the previously tax-favoured asset: UK equities. Given that UK pension funds are small relative to the total size of the world capital market, a small open economy-type argument implies that the main effect of the reform would be to reduce UK pension funds’ ownership of UK equities, with little impact on the price of UK equities. We present evidence which is consistent with these hypotheses. We discuss why previous research (Bell and Jenkinson, 2002) reached the different conclusion that this tax reform had a large negative impact on UK share prices.