This study examines the relations between dividend policy, the differential taxation of dividends and capital gains, and stock prices. The Tax Reform Act of 1986 (TRA 86) eliminated the capital gains preference and reduced individual income tax rates, both of which affect after-tax returns. Extant theory and prior research predict the change in equilibrium will cause high-dividend yielding securities to be tax favored relative to low-dividend yielding stocks. This will be manifested as shifts in relative stock prices as investors bid up high-dividend yielding firms. Prior studies have generally reported mixed results, and important questions remain to be examined. Using an event study methodology over the TRA 86 enactment period, this study extends prior research by controlling for the possible confounding factors of cross-sectional correlation, heteroskedasticity, and firm size. In addition, an alternative explanation (risk shifts) is tested.; Employing a sample of 281 New York Stock Exchange (NYSE) firms, this study finds a positive abnormal return for high-dividend yielding firms relative to low-dividend yielding firms on several important event dates. The results also support the hypothesis that firms' betas shifted in response to TRA 86, and the evidence suggests that the beta shift is a partial explanation for the observed abnormal returns.; The findings should have important implications for both policy makers and future research. Policy makers should be aware that tax law changes create wealth transfers and introduce additional volatility in the market. Future research efforts should, at the least, consider the need to control for size effects and beta shifts.
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