Equity Security Investments: Evidence on Tax-Induced Dividend Clienteles

This study examines the formation of tax-induced dividend clienteles in equity security holdings by life insurance companies (LICs). Generally, corporations are allowed a 70 percent deduction against dividends received from portfolio stocks. In contrast, LICs are only allowed a “prorated” dividends-received deduction (DRD) that ranges between 0 percent and 70 percent. So, even with similar levels of profitability, the marginal tax rate on dividend income effectively varies across LICs. This setting provides a unique opportunity to isolate and examine the effect of taxes on dividend clientele formation. Cross-sectional regression is used to analyze the relation between the prorated DRDs and the average dividend yield on equity holdings. Controls are added for other determinants of equity investment behavior. The results show that LICs' prorated DRDs significantly influence their average dividend yield on equity investments, providing direct evidence that investment behavior is consistent with tax-induced dividend clientele formation.