This study examines the effects of dividend taxation on the primary parties involved in a short sale: the lender of the stock and the short seller. For stock lenders, dividend taxation is associated with a decrease in the supply of shortable shares and an increase in equity lending fees around the dividend record date. For short sellers, potential reimbursement costs are associated with a significant decrease in short volume before the ex-dividend date followed by a significant increase after the ex-date. Prior research shows that short selling improves price efficiency and formation. Hence, because of the negative effects of taxation on shorting, market quality declines along several dimensions: equity mispricing, increased loan search frictions, loan price inefficiencies, and market microstructure breakdown. In sum, this study documents that taxation constricts the shorting market around the dividend dates, which in turn has negative implications for market quality.
JEL Classifications: G11, G12, G23, H20