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Timing of Tax Payments
When the 1986 tax law was signed into law, equalizing tax rates on ordinary
income and capital gains, some believed that all the tax disadvantages of dividends had
disappeared. Others noted that, even with the same tax rates, dividends carried a tax
disadvantage because the investor had no choice as to when to report the dividend as
income; taxes were due when the firm paid out the dividends. In contrast, investors
retained discretionary power over when to recognize and pay taxes on capital gains, since
such taxes were not due until the stock was sold. This timing option allowed the investor
to reduce the tax liability in one of two ways. First, by taking capital gains in periods of
low income or capital losses to offset against the gain, the investor could now reduce the
taxes paid. Second, deferring a stock sale until an investor™s death could result in tax
savings. Since the tax rates on capital gains have decreased relative to the tax rates on
dividends since, this timing option should make capital gains an even more attractive
option now.

Assessing Investor tax preferences for dividends
As you can see from the discussion above, the tax rate on dividends can vary
widely for different investors “ individual, pension fund, mutual fund or corporation “
receiving the dividends and even for the same investor on different investments. It is
difficult therefore to look at a company™s investor base and determine their preferences
for dividends and capital gains. A simple way to measure the tax disadvantage associated
with dividends is to measure the price change on the ex-dividend date and compare it to
the actual dividend paid. The stock price on the ex-dividend day should drop to reflect the
loss in dividends to those buying the stock after that day. It is not clear, however, whether
the price drop will be equal to the dividends if dividends and capital gains are taxed at
different rates.


To see the relationship between the price drop and the tax rates of the marginal
investor, assume that investors in a firm acquired stock at some point in time at a price P,
and that they are approaching an ex-dividend day, in which the dividend is known to be
D. Assume that each investor in this firm can either sell the stock before the ex-dividend
day at a price PB or wait and sell it after the stock goes ex-dividend at a price PA. Finally,
assume that the tax rate on dividends is to and that the tax rate on capital gains is tcg. The
cash flows the investor will receive from selling before the stock goes ex-dividend is “
CFB = PB - (PB - P) tcg
In this case, by selling before the ex-dividend day, the investor receives no dividend. If
the sale occurs after the ex-dividend day, the cash flow is “
CFA = PA - (PA - P) tcg + D (1-to)
If the cash flow from selling before the ex-dividend day were greater than the cash flow
from selling after, the investors would all sell before, resulting in a drop in the stock
price. Similarly, if the cash flows from selling after the ex-dividend day were greater than
the cash flows from selling before, every one would sell after, resulting in a price drop
after the ex-dividend day. To prevent either scenario, the marginal investors in the stock
have to be indifferent between selling before and after the ex-dividend day. This will
occur only if the cash flows from selling before are equal to the cash flows from selling
PB - (PB - P) tcg = PA - (PA - P) tcg + D (1-to)
This can be simplified to yield the following ex-dividend day equality:

PB ! PA (1- t o )
D (1 ! tcg )
Thus, a necessary condition for the marginal investor to be indifferent between selling
before and after the ex-dividend day is that the price drop on the ex-dividend day must
reflect the investor™s tax differential between dividends and capital gains.
Turning this equation around, we would argue that by observing a firm™s stock
price behavior on the ex-dividend day and relating it to the dividends paid by the firm, we
can, in the long term, form some conclusions about the tax disadvantage the firm™s
stockholders attach to dividends. In particular:
If Tax Treatment of Dividends and Capital Gains


PB - PA = D Marginal investor is indifferent between dividends and capital
PB - PA < D Marginal investor is taxed more heavily on dividends
PB - PA > D Marginal investor is taxed more heavily on capital gains
While there are obvious measurement problems associated with this measure, it does
provide some interesting insight into how investors view dividends.
The first study of ex-dividend day price behavior was completed by Elton and
Gruber in 1970.8 They examined the behavior of stock prices on ex-dividend days for
stocks listed on the NYSE between 1966 and 1969. Based upon their finding that the
price drop was only 78% of the dividends paid, Elton and Gruber concluded that
dividends are taxed more heavily than capital gains. They also estimated the price change
as a proportion of the dividend paid for firms in different dividend yield classes and
reported that price drop is larger, relative to the dividend paid, for firms in the highest
dividend yield classes than for firms in lower dividend yield classes. This difference is
price drops, they argued, reflected the fact that investors in these firms are in lower tax
brackets. Their conclusions were challenged, however, by some who argued, justifiably,
that the investors trading on the stock on ex-dividend days are not the normal investors in
the firm; rather, they are short-term, tax-exempt investors interested in capturing the
difference between dividends and the price drops.

There can be no argument that dividends have historically been treated less
favorably than capital gains by the tax authorities. In the United States, the double
taxation of dividends, at least at the level of individual investors, should have created a
strong disincentive to pay or to increase dividends. Other implications of the tax
disadvantage argument include the following:
Firms with an investor base composed primarily of individuals typically should have

paid lower dividends than do firms with investor bases predominantly made up of
tax-exempt institutions.

8 Elton, E.J. and M.J. Gruber, 1970, Marginal Stockholder Rates and the Clientele Effect, Review of
Economics and Statistics, v52, 68-74.


The higher the income level (and hence the tax rates) of the investors holding stock in

a firm, the lower the dividend paid out by the firm.
As the tax disadvantage associated with dividends increased, the aggregate amount

paid in dividends should have decreased. Conversely, if the tax disadvantage
associated with dividends decreased, the aggregate amount paid in dividends should
have increased.
The tax law changes of 2003 have clearly changed the terms of this debate. By reducing
the tax rate on dividends, they have clearly made dividends more attractive at least to
individual investors than they were prior to the change. We would expect companies to
pay more dividends in response. While it is still early to test out this hypothesis, there is
some evidence that companies are changing dividend policy in response to the tax law
change. Technology companies like Microsoft that have never paid dividends before have
initiated dividends. In figure 10.11, we look at the percent of S&P 500 companies that
pay dividends by year and the dividends paid as a percent of the market capitalization of
these companies from 1960 to 2003.


There was an up tick in both the number of companies paying dividends in 2003 and the
dividends paid, reversing a long decline in both statistics. It will be interesting to see
whether this continues into the future.
In Practice: Dividend Policy for the next decade
As firms shift towards higher dividends, they may be put at risk because of
volatile earnings. There are two ways in which they can alleviate the problem.
One is to shift to a policy of residual dividends, where dividends paid are a function

of the earnings in the year rather than a function of dividends last year. Note that the
sticky dividend phenomenon in the US, where companies are reluctant to change their
dollar dividends, is not a universal one. In countries like Brazil, companies target
dividend payout ratios rather than dollar dividends and there is no reason why US
companies cannot adopt a similar practice. A firm that targets a constant dividend
payout ratio will pay more dividends when its earnings are high and less when its
earnings are low, and the signaling effect of lower dividends will be mitigated if the
payout policy is clearly stated up front.
The other is to adopt a policy of regular dividends that will be based upon sustainable

and predictable earnings and to supplement these with special dividends when
earnings are high. In this form, the special dividends will take the place of stock
In summary, you can expect both more dividends from companies and more creative
dividend policies, if the dividend tax law stands. British Petroleum provided a preview of
innovations to come by announcing that they would supplement their regular dividends
with any extra cashflows generated if the oil price stayed above $ 30 a barrel, thus
creating dividends that are tied more closely to their cashflows.

10.6. ˜: Corporate Tax Status and Dividend Policy
Corporations are exempt from paying taxes on 70% of the dividends they receive from
their stockholdings in other companies, whereas they face a capital gains tax rate of 20%.
If all the stock in your company is held by other companies, and the ordinary tax rate for
companies is 36%,
a. dividends have a tax advantage relative to capital gains


b. capital gains have a tax advantage relative to dividends
c. dividends and capital gains are taxed at the same rate

The “Dividends Are Good” School
Notwithstanding the tax disadvantages, firms continue to pay dividends and they
typically view such payments positively. A third school of thought that argues dividends
are good and can increase firm value. Some of the arguments used by this school are
questionable, but some have a reasonable basis in fact. We consider both in this section.

Some Reasons for Paying Dividends that do not measure up
Some firms pay and increase dividends for the wrong reasons. We will consider
two of those reasons in this section.

The Bird-in-the-Hand Fallacy
One reason given for the view that investors prefer dividends to capital gains is
that dividends are certain, whereas capital gains are uncertain. Proponents of this view of
dividend policy feel that risk averse investors will therefore prefer the former. This
argument is flawed. The simplest counter-response is to point out that the choice is not
between certain dividends today and uncertain capital gains at some unspecified point in
the future, but between dividends today and an almost equivalent amount in price
appreciation today. This comparison follows from our earlier discussion, where we noted
that the stock price dropped by slightly less than the dividend on the ex-dividend day. By
paying the dividend, the firm causes its stock price to drop today.
Another response to this argument is that a firm™s value is determined by the cash
flows from its projects. If a firm increases its dividends but its investment policy remains
unchanged, it will have to replace the dividends with new stock issues. The investor who
receives the higher dividend will therefore find himself or herself losing, in present value
terms, an equivalent amount in price appreciation.


Temporary Excess Cash
In some cases, firms are tempted to pay or initiate dividends in years in which
their operations generate excess cash. Although it is perfectly legitimate to return excess
cash to stockholders, firms should also consider their own long-term investment needs. If
the excess cash is a temporary phenomenon, resulting from having an unusually good
year or a non-recurring action (such as the sale of an asset), and the firm expects cash
shortfalls in future years, it may be better off retaining the cash to cover some or all these
shortfalls. Another option is to pay the excess cash as a dividend in the current year and
issue new stock when the cash shortfall occurs. This is not very practical because the
substantial expense associated with new security issues makes this a costly strategy in the
long term. Figure 10.12 summarizes the cost of issuing bonds and common stock, by size
of issue in the United States.9

Source: Ibbotson, Sindelar and Ritter (1997)

9 Ibbotson, R. G., J. L. Sindelar and J. R. Ritter. 1988, Initial Public Offerings, Journal of Applied
Corporate Finance, v1(2), 37-45.


Since issuance costs increase as the size of the issue decreases and for common
stock issues, small firms should be especially cautious about paying out temporary excess
cash as dividends. This said, it is important to note that some companies do pay dividends
and issue stock during the course of the same period, mostly out of a desire to maintain
their dividends. Figure 10.13 reports new stock issues by firms as a percentage of firm
value, classified by their dividend yields, in 1998.

Figure 21.11: Equity Issues by Dividend Class, United States - 1998

7.0% 60.00%


Percent of Firms making Equity Issues
Equity Issues as % of Market Value

New Issue Yld
New Issues



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