15.3The Effect of Taxes and Transaction Costs on Distribution Policy

Any discussion of tax reform in Washington almost always includes a discussion about

the double taxation of corporate profits. As discussed in Chapter 14, corporations first

pay corporate taxes on their earnings, and shareholders pay tax again on the distributed

profits. Example 15.2 illustrates that from a shareholder’s perspective, the effective tax

on corporations can be considerable:⁵

Example 15.2:The Effective Tax Rate on MGI’s Profits

MGI earned $100 million in pretax profits in 1996.Its corporate tax rate is 34 percent.Joe

Gecko, who owns 10 percent of the firm’s shares, has a personal marginal tax rate of 33.33

percent.From Gecko’s perspective, what is the effective tax rate on MGI’s profits if its entire

after-tax profits are distributed as a dividend?

Answer:MGI will pay $34 million in corporate taxes and distribute $66 million to share-

holders in the form of a dividend.Gecko thus receives $6.6 million in dividends and pays

$2.2 million in personal taxes, leaving him with $4.4 million after taxes from his $10 million

share of the firm’s pretax profits.From Gecko’s perspective, the effective tax rate on corpo-

rate profits is 56 percent [ ($3.4 million $2.2 million)/$10 million].

⁵There are other ownership forms that are not double taxed. For example, most small firms in the

United States are incorporated as subchapter S corporations, which are not taxed at the corporate level

but which pass through their earnings directly to shareholders who pay a personal tax on the income.

Subchapter S corporations allow only a limited number of shareholders and thus cannot be used for

larger firms. Most real estate firms are set up as master limited partnerships or real estate investment

trusts, which also pass through all earnings directly to shareholders and are not taxed at the firm level.

Limited liability companies (LLCs) are an increasingly popular form of organization that has the

passthrough feature combined with limited liability.

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Chapter 15

How Taxes Affect Dividends and Share Repurchases

539

AComparison of the Classical and Imputation Tax Systems

Anumber of countries outside the United States have changed their tax systems to elim-

inate the double taxation of corporate profits. Greece and Norway, for example, allow

dividends to be deducted from corporate taxes and thus treat dividends and interest pay-

ments symmetrically. Australia, Canada, France, Germany, Italy, and the United King-

dom have introduced imputation systems, under which investors who receive taxable

dividends get a tax credit for part or all of the taxes paid by the corporation. This tax

credit at least partly offsets the personal taxes these investors must pay on dividend

income.

The discussion in this section focuses on what is known as the classical tax sys-

temwhich is observed in the United States. In a classical tax system, dividends are

taxed as ordinary income and capital gains are generally taxed at a lower rate than ordi-

nary income. As of 2001, the maximum federal tax rate on dividends and other ordi-

nary income was 39.1 percent and the capital gains rate for investments held at least

one year was 20 percent.⁶Shareholders do not receive tax credits, offsetting the taxes

paid by corporations, implying that the classical tax system effectively double taxes

corporate profits.

Financial economists and policymakers have expressed concern about the adverse

consequences of the classical tax system and suggested that the United States move to

an imputation system. In particular, under the classical system the cost of funding

investments through retained earnings is lower than the cost of funding investment by

issuing new equity. As a result, new firms with promising opportunities but insufficient

amounts of internally generated cash will find it more expensive to fund their invest-

ment needs than more mature firms with less promising opportunities.

How Taxes Affect Dividend Policy

Personal taxes on dividends can profoundly affect a firm’s choice between paying div-

idends and repurchasing shares. Because the pretax proceeds from both strategies are

equal, the only difference between the two methods of cash distribution is the amount

of the tax liability generated by each.

The Tax Disadvantage of Dividends.Exhibit 15.4 details the immediate tax conse-

quences to an individual investor, if a firm chooses to distribute $100 million in the

form of a dividend versus distributing $100 million as a share repurchase. It assumes

that the investor currently owns 10 percent of the outstanding shares and plans on main-

taining the 10 percent ownership. It also assumes that the shares, if repurchased, will

be repurchased at a price of $50 a share and that they were originally purchased at a

price of $38 a share. It uses 35 percent as the tax rate on dividends and 20 percent as

the tax rate on capital gains.

Although the immediatetax liability is considerably higher with the dividend alterna-

tive, the futuretax liability incurred by shareholders when their shares are eventually sold

is higher when shares are repurchased. This is because the share prices drop by the amount

⁶Until 1982, the tax on dividend income in the United States could be as high as 70 percent while

capital gains were taxed at 50 percent of the ordinary rate. With the passage of the Tax Equity and Fiscal

Responsibility Act of 1982, the maximum tax on dividends fell to 50 percent and that on capital gains

was reduced to 20 percent. Since 1987, the maximum tax rate on dividends has fluctuated between 33

percent and 39.6 percent, while the rate on capital gains has fluctuated between 20 percent and

28percent. Under the 2001 tax bill, the highest rate on ordinary income is scheduled to decline in

increments to 35 percent by 2006.

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540	Part IVCapital Structure

EXHIBIT15.4

Tax Consequences: Dividend versus Share Repurchase (in$millions)

Dividend Alternative
Dividend	$100.0

Tax rate	35%
Immediate tax liability	$35.0

Share Repurchase Alternative
Proceeds from sale of 2 million shares	$100.0

Less original cost (at $38/share)	76.0
Taxable capital gain	$24.0
Tax rate	20%
Immediate tax liability	$4.8

of the dividend when a dividend is paid, making the future capital gains lower for share-

holders who purchased stock prior to the dividend. However, the total amount paid in taxes

(and its present value) is still considerably lower with the repurchase alternative.

Result 15.3

In the United States, taxes favor share repurchases over dividends. The gain associated witha share repurchase over a cash dividend depends on:

•	The difference between the capital gains rate and the tax rate on ordinary income.
•	The tax basis of the shares—that is, the price at which the shares were purchased.
•	The timing of the sale of the shares (if soon, the gain is less, but if too soon, thegain may not qualify for the long-term capital gains rate).

Can Individual Investors Avoid the Dividend Tax?Miller and Scholes (1978) claimed

that individual investors should be indifferent between repurchases and dividends because

they can avoid the tax on dividends. Their dividend tax avoidance scheme is quite sim-

ple: An individual borrows money and invests in tax-deferred insurance annuities. The

interest on the loan is tax deductible and can offset the taxable dividend income but not

the individual’s labor income. However, the tax on the insurance annuity can be deferred

indefinitely. These transactions are illustrated in Example 15.3:

Example 15.3:Deferring the Dividend Tax

Elliot Jackson has $12,000 in dividend income.How can he defer the taxes on this dividend

if he can borrow at 6 percent and insurance annuities pay an interest rate of 6 percent?

Answer:Elliot should borrow $200,000 at 6 percent and invest the proceeds in a tax-

deferred insurance annuity.By doing this, the tax on the $12,000 dividend is deferred (since

the dividend is offset by the $12,000 interest payment) until the money is withdrawn from

the insurance annuity.

In reality, individual investors rarely avoid the dividend tax in the way that Miller

and Scholes suggest. Indeed, Feenberg (1981) found that individual investors paid over

$8 billion in taxes on dividend income in 1977. Similar findings by Peterson, Peterson,

and Ang (1985) indicated that individual tax returns included more than $33 billion of

dividend income in 1979, which was slightly more than two-thirds of the total amount

of dividends paid by U.S. corporations. Thus, since shareholders seem unable to avoid

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Markets and Corporate		Dividends and Share	Companies, 2002
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Chapter 15

How Taxes Affect Dividends and Share Repurchases

541

taxes on dividends, the argument of Miller and Scholes fails to explain why corpora-

tions continue to pay dividends given the tax advantages of share repurchases.

The Miller and Scholes insights may be useful for individuals wishing to reduce

their own taxes. However, deferring taxes may be more difficult in practice than in

theory. It requires, for example, that investors be able to borrow on the same terms that

they invest in the insurance annuity, matching investment horizon as well as rates. It

also assumes that there are no costs associated with such transactions.

Dividend Clienteles

The tax advantages of a share repurchase do not apply to all investors. Alarge per-

centage of investors are tax exempt (for example, pension funds and university endow-

ments). As previously demonstrated, these investors are indifferent between receiving

dividends or having the firm repurchase shares when there are no transaction costs. In

reality, however, transaction costs do exist. Shareholders and the firm must pay bro-

kerage fees as part of a share repurchase. Also, shares repurchased with a tender offer

usually carry underwriting fees and registration costs. Although these transaction costs

are small relative to the tax gains enjoyed by taxable investors with repurchases, they

might lead tax-exempt investors to prefer dividends.

As Chapter 14 noted, corporations that hold shares in other corporations may also

prefer dividends to share repurchases since only 30 percent of their dividend income

is taxable while their capital gains are fully taxed. Large investors who hold their shares

within a corporate form (for example, Kerkorian’s Tracinda Corporation) also may pre-

fer dividends to a share repurchase. In addition, many individuals and institutions that

receive income from trust funds may prefer higher dividend-paying stocks if the ben-

eficiary of the trust is allowed to spend the income but not the principal of the trust.

Some authors have suggested that different firms have different dividend payout

ratios to appeal to different investorclienteles; that is, the different groups of investors

with different tastes for receiving dividend income. Firms that pay no dividends are

likely to attract individual investors in high tax brackets while firms that pay large div-

idends are likely to attract tax-exempt institutions, individual investors in low marginal

tax brackets, and corporations attracted by the dividend tax preference.

Empirical tests by Pettit (1977) and Lewellen, Stanley, Lease, and Schlarbaum (1978)

provide evidence that the dividend yields of investors’portfolios are indeed related to

their marginal tax rates. Investors with high marginal tax rates tend to select stocks with

low dividend yields and investors with low or zero marginal tax rates tend to select stocks

with high dividend yields. Firms, however, do not appear to vary their dividends in order

to satisfy the demands of different tax clienteles. Dividend policies of similar firms usu-

ally exhibit great similarity. This makes it extremely difficult for investors to specialize

in terms of dividend yields for their portfolios and still diversify their portfolios ade-

quately. For example, an investor in a high tax bracket would find it very difficult to find

a utility with a low dividend yield while an investor with a desire for dividends would

find it equally difficult to find a biotech firm with a high dividend yield.

Why Do Corporations Pay Out So Much in Taxed Dividends?

The previous subsection suggested that some investors prefer dividends to share

repurchases while others prefer share repurchases to dividends. However, the divi-

dend tax borne by the taxable investor is likely to be larger than the transaction costs

associated with a repurchase, suggesting that corporate values would probably

increase if firms cut their dividends and repurchased shares instead. This has led a

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542Part IVCapital Structure

number of financial economists to suggest that the dividend policy of U.S. firms is

somewhat of a puzzle.⁷

To understand why U.S. dividend policy is so puzzling, consider the situation

in the United States during the 1960s and 1970s. The majority of investors during

this period were individual investors, many of whom paid taxes at marginal tax rates

as high as 70 percent. For these investors, the tax advantage of a share repurchase

over a dividend was very large, but repurchases were uncommon at that time. While

we can only speculate on why U.S. firms paid out so much in tax-disadvantaged

dividends at that time, our best guess is that the decisions of financial managers at

that time were simply wrong and that most shareholders would have been better off

if corporations had cut dividends and, instead, repurchased shares.

The explosion in repurchase activity that began in the 1980s supports the hypoth-

esis that most managers previously had misunderstood the relation between dividends

and share repurchases and were changing their behavior to reflect their improved under-

standing of the tax advantage of share repurchases. Of course, other changes, such as

the SEC ruling mentioned earlier, may have been taking place in the 1980s that would

have made repurchases more attractive than dividends. However, the tax law changes

in 1982 and 1986, which substantially decreased the tax disadvantage of dividends,

should have had the opposite effect. In addition, the percentage of stock held by tax-

exempt institutions greatly increased over this period, increasing the percentage of

shareholders who might prefer dividends to share repurchases. These two changes had

the effect of making dividends a relatively more attractive vehicle for paying out cor-

porate cash than they previously were. Yet, share repurchases were, and still are, becom-

ing increasingly popular.