The Effects of Changes in Tick Size and Tax Rates on the Tax-Timing Option and the Market Response to Stock Distributions

Abstract

This study examines how changes in tick size and the differential between short-term and long-term capital gain tax rates affect the market response to the announcement of stock distributions. Prior research finds that a stock distribution increases the volatility of the stock, which in turn increases the value of the stock’s tax-timing option. We show that the minimum tick size established by the exchange where the stock is traded affects a stock’s volatility and, therefore, the value of the tax-timing option and the market response to the stock distribution. We document a stronger relation between the market response and changes in volatility among large distributions than among small distributions. We also find a positive relation between the market response and the tax rate differential, although it is only significant for small distributions. Finally, we show that the relationship between the market response and changes in both volatility and tax rate differential is primarily driven by tax-sensitive institutional investors in the distributing firm.