Stock market reactions to dividend and earnings announcements in a tax‐free environment

• DOI: http://doi.org/10.1111/infi.12331
• Date: 01 August 2019
• Published date: 01 August 2019

DOI: 10.1111/infi.12331

ORIGINAL ARTICLE

Stock market reactions to dividend and earnings

announcements in a tax-free environment

Kienpin Tee

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Abiot M. Tessema

Zayed University College of Business,

Abu Dhabi, United Arab Emirates

Correspondence

Abiot M. Tessema, Zayed University

College of Business, P.O. Box 144354,

Abu Dhabi, United Arab Emirates.

Email: abiot.tessema@zu.ac.ae

Abstract

This paper investigates the stock market reactions to

dividend and earnings announcements for firms listed in the

United Arab Emirates (UAE), where there is no tax on

dividend income or capital gains. This tax-free setting

allows us to examine the tax-based signalling hypothesis,

which holds that a change in dividends does not offer

important information when dividend income is not taxed.

Contrary to the tax-based signalling theory, we find a

positive (negative) price reaction to dividend initiations and

increases (dividend omissions and decreases). We further

examine the signalling hypothesis, which proposes that

dividends convey information about firms' future earnings.

We find that the size of the dividend increases or decreases

does not predict future earnings.

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INTRODUCTION

Why do companies pay dividends? This question has beena riddle for decades, since Black (1976) first

proposed the idea of the ‘DividendPuzzle’. Black asked why companies paid dividendswhen they were

taxed higher thancapital gains. Forty years later, there is not a conclusiveanswer. A popular explanation

is the tax-basedsignalling theory, which proposesthat it is actually the costly tax on dividendsthat makes

dividends informative about company values (Amihud & Murgia, 1997; Bernheim & Wantz, 1995;

Bhattacharya,1979; John & Williams, 1985). According to this theory,companies that can afford to pay

dividends must havemotives to send important and expensive signals.Dividend announcements would

not be valuable if the dividend tax was not higher than the capital gains tax.

Kienpin Tee and Abiot M. Tessema contributed equally to this manuscript.

International Finance. 2018;1–19. wileyonlinelibrary.com/journal/infi © 2018 John Wiley & Sons Ltd

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International Finance. 2019;22:241–259. wileyonlinelibrary.com/journal/infi © 2018 John Wiley & Sons Ltd

The United Arab Emirates (UAE), unlike the US and many other countries, offers zero withholding

tax on dividends and no levy tax on capital gains. Such a tax-free environment provides an ideal

platform to examine the tax-based dividend signalling theory, which assumes that when there is a tax

on dividends the costs associated with dividend payments are greater (Bernheim & Wantz, 1995).

Although numerous studies have examined stock price reactions to dividend announcements, they

have produced mixed and inconclusive results. Moreover, even though dividend and earnings

announcements usually appear simultaneously, few studies have examined the interaction effect of

dividend and earnings announcements on stock prices. To the best of our knowledge, prior studies that

have examined the effect of dividend and earnings announcements focus on developed markets data

(Easton, 1991; Kane, Lee, & Marcus, 1984; Lonie, Abeyratna, Power, & Sinclair, 1996). Therefore,

this study aims to fill the above gaps by examining (i) the information content of dividend

announcements and (ii) stock market reactions to dividend and earnings announcements using a sample

of firms listed on the UAE stock markets.

In addition to the country's tax-free setting, several other important structural and institutional

features make the UAE an interesting environment to study the market reaction to cash dividend

announcements. First, although the UAE is one of the wealthiest countries, with one of the highest per

capita incomes in the world, the UAE's financial markets are ranked as emerging markets.

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phenomenon of emerging financial markets is a scarcity of coverage from financial analysts and mass

media. The fact that investors in the UAE have limited sources of information on UAE companies has

resulted in a less efficient and low-turnover stock market. In the UAE, management possesses more

information about a firm's current performance and future prospects than investors do (Al-Shammari,

Brown, & Tarca, 2008), and investors rely a great deal on the signals from management (Amihud &

Murgia, 1997). Due to the problem of information asymmetry, investors rely on signals from all

sources of financial news, including dividend announcements from the firms. Second, UAE companies

are owned by a small number of shareholders who have controlling interests, and the major

shareholders are usually agents of the local government or members of the royal families. Large

investors with a significant stake may have a particular interest in the firm's long-term growth and

performance and are better able to resolve the principal-agent problem with management by using their

own resources to closely monitor the firm's operations (Alimehmeti & Paletta, 2012). If the

concentration of ownership resulted in decreased information asymmetry between managers and

shareholders, then dividend announcements should have little pricing effects in the UAE. However,

Shleifer and Vishny (1997) indicated that when the ownership is concentrated, the conflict of interest

shifts away from managers versus shareholders to majority versus minority shareholders, as large

shareholders have incentives to maximize their own benefits at the cost of other shareholders. Prior

studies have provided mixed evidence on the impact of concentrated ownership on dividend policy. For

example, De Cesari (2012) documented that firms paid higher dividends when the agency conflict

between large and small owners was stronger, suggesting that firms disburse higher dividend payouts

to signal that insiders will refrain from expropriation. However, entrenchment behavior theory predicts

that both managers and major shareholders might have incentives to pay only small dividends to

increase the amount of free cash flow they can divert for their private compensation (Gomes, 2000). As

a result, firms pay lower dividends as the level of information asymmetry increases. Consistent with

entrenchment theory, Li and Zhao (2008) found that firms with higher levels of information asymmetry

distribute lower dividends.

Using a sample of firms listed on the UAE stock market from 2004 to 2015, we find that the stock

price is significantly higher for dividend increase and dividend initiation announcements; additionally,

we find that the stock price is significantly lower for dividend decrease and dividend omission

announcements. Meanwhile, a firm with no change in dividend payments realizes normal returns. This

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