We develop a theory in which the decision to pay dividends is driven by investor demand. Managers cater to investors by paying dividends when investors put a stock price premium on payers and not paying when investors prefer nonpayers. To test this prediction, we construct four time series measures of the investor demand for dividend payers. By each measure, nonpayers initiate dividends when demand for payers is high. By some measures, payers omit dividends when demand is low. Further analysis confirms that the results are better explained by the catering theory than other theories of dividends.

In perfect and complete financial markets Miller and Modigliani (1961) show that a firm’s value is unaffected by its dividend policy. Taxation, asymmetric information, incomplete contracts, institutional constraints, and transaction costs cause their theorem to fail in practice. We examine the effects of dividend policies on 323 securities that were listed on the London Stock Exchange between 1895 and 1905. The London Stock Exchange operated in an environment of very low taxation and an absence of institutional constraints. This allows us to investigate the worthiness of signalling and agency theories of dividend policy in a setting where many of the imperfections of modern markets do not exist.

We exploit demographic variation to identify the effect of dividend demand on corporate payout policy. Retail investors tend to hold local stocks and older investors prefer dividend-paying stocks. Together, these tendencies generate geographically-varying demand for dividends. Firms headquartered in areas in which seniors constitute a large fraction of the population are more likely to pay dividends, initiate dividends, and have higher dividend yields. We also provide indirect evidence as to why managers may respond to the demand for dividends from local seniors. Overall, these results are consistent with the notion that the investor base affects corporate policy choices.

This paper investigates how dividend taxes influence portfolio choices, using the response to the distinctive treatment of a subset of foreign dividends in the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003. An open-economy after-tax capital asset pricing model is used to derive the hypothesis that JGTRRA should lead to a portfolio reallocation by US investors towards equities in tax-favored countries. A difference-in-difference analysis that compares US equity holdings in affected and unaffected countries finds a substantial portfolio reallocation towards the former. This effect cannot be explained by several potential alternative hypotheses, including differential changes to the preferences of American investors, differential changes in investment opportunities, differential time trends in investment, changed tax evasion behavior, or changes in stock prices associated (or contemporaneous) with JGTRRA.

The authors thank The Global Association of Risk Professionals (GARP) for funding. We are especially grateful to Brian Bushee for providing his data on institutional ownership classifications. We thank Paul Zarowin and seminar participants at New York University, the London Business School, INSEAD, the University of Rochester, and Southern Methodist University for helpful suggestions on an earlier version of the paper, and David Barker, Matt Billett, Brian Bushee, Eric Lie, Anand Vijh, and seminar participants at the University of Iowa for comments on this version. Minton acknowledges financial support from the Dice Center for Research in Financial Economics. Investor clienteles and industry factor-price exposure We find robust evidence of investor clienteles for industry factor-price exposure: Investor interest, measured using share turnover and the number of institutions that hold a firm’s stock, is positively associated with stocks ’ industry exposure, and institutional investors systematically overweight (underweight) high (low) industry exposure stocks in their portfolios. Clientele effects are most pronounced in industries in which return correlation with the aggregate market is low, where the benefits from learning about industry risk and from substituting investment in high-exposure stocks for investment in the industry assets are greatest. Clientele effects are

Please do not cite without author’s permission. In this paper, I test the dividend clientele hypothesis (DCH) by examining the impact of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the 2003 tax act) on household portfolio dividend yields. The DCH predicts that the 2003 tax act, which reduced the tax-disadvantage of dividends differentially across the income distribution, would cause high income households to shift their portfolios towards dividend paying stocks relatively more than lower income households. Using the 2001 and 2004 Surveys of Consumer Finances (SCF), I examine how changes in tax rates affect changes in household portfolio dividend yields. I find that the 2003 tax act caused households in the highest (35%) tax bracket to increase their portfolio dividend yields by 1.1 percentage points more than those in the next (33%) tax bracket, and by 2.6 percentage points more than those two tax brackets (28%) below. Compared to a 2.1 percent average dividend yield in 2001, these responses are large and economically significant. Using the 2007 SCF, I find that the reduced variation in dividend tax rates across households caused portfolio dividend yields to become homogeneous within three years of the tax act. Using a battery of sensitivity checks, I verify that these findings are not driven by other explanations for changes in dividend preferences, such as changes in optimism or risk-aversion. ∗I am grateful to my dissertation committee members, Amy Dittmar, Matthew Shapiro, Joel Slemrod and Jeff Smith for invaluable guidance, to Kevin Moore for assistance with using the Survey of Consumer

Work in process. Comments are welcome. Tax reforms which affect the taxation of corporate dividends offer excellent opportunities to study dividend clientele effects. We study payout policy changes (dividends and share repurchases) around a major tax reform in Finland in 2004. Contrary to e.g. survey results by Brav et al (2005), who report that executives believe that dividend policies have little impact on their investor clientele, and that tax considerations play a secondary role, we find that firms adjust their dividend policies in line with the preferences of their main shareholders. We also find that dividend preferences play a significant role in explaining ownership structures in Finnish firms.

This paper investigates whether investors are compensated for the tax burden of equity securities. Effective tax rates on equity securities vary due to frequent tax reforms and due to persistent differences in propensities to pay dividends. The paper finds an economically and statistically significant relationship between risk-adjusted stock returns and effective personal tax rates using a new data set covering tax burdens on a cross-section of equity securities between 1927 and 2004. Consistent with tax capitalization, stocks facing higher effective tax rates tend to compensate taxable investors by generating higher before-tax returns.

Working papers in this series are preliminary and are circulated to stimulate discussion and critical comment. These papers are not subject to CBO’s formal review and editing processes. The analysis and conclusions expressed in them are those of the authors and should not be interpreted as those of the Congressional Budget O ¢ ce. References in publications should be cleared with the authors. Papers in this series can be obtained at www.cbo.gov/publications/. 1 The Impact of Progressive Dividend

Models of dividend preferences (clienteles) can lead to biased results if they ignore the connection between market participation and asset allocation decisions. Using data from the Consumer Expenditure Survey (CEX), I jointly model and estimate these investment decisions with a two-step procedure due to Heckman (1977). The estimated coefficients support the idea that market frictions and behavioral biases combine to affect US households ’ asset allocation and market participation. Households with more diversified income are less likely to join the market and, when they do, are less likely to rely on dividends. Age positively affects dividend preference only for older consumers, while it has almost no effect on market participation. Income positively affects market participation and dividend preferences. Education encourages market participation. Consumers without a college degree account for most of the documented anomalous investment behavior.