15.6Personal Taxes, Payout Policy, and Capital Structure

Recall that in Chapter 14 we argued that given reasonable assumptions about corporate

and personal tax rates on debt and equity, U.S. tax laws favored debt over external

equity financing. However, in the last section we also showed that financing projects

with retained earnings, by paying corporate rather than personal taxes on their returns,

provides an added benefit to shareholders with higher personal tax rates on their invest-

ment returns than the corporation pays. With the Bill Gates example, we showed that

these same investors may even want the firm to use retained earnings to invest in finan-

cial assets, including debt, on their behalf.

Corporations must recognize that the incentives associated with payout policy also

have implications for capital structure. Afirm that pays out retained earnings to its

shareholders, by reducing the amount of equity outstanding, increases its leverage ratio.

Such a firm also increases the total dollar amount of debt financing relative to using

those same retained earnings as “internal equity financing” for new investment. This is

because the external financing that makes up for the payout is more likely to be in the

form of debt given its tax advantage over external equity.

The arguments in the last section can be extended to show that the firm will want

to fund new investment with retained earnings rather than debt if the firm’s share-

holders’personal tax rate on debt exceeds the corporate tax rate. This can be seen if

we view the investment illustrated in Exhibit 15.5 as paying off some of the firm’s

¹²Until

1987, corporations were taxed on only 15 percent of their dividend income. This was raised to

20 percent in 1987 and 30 percent in 1988. Corporations that own between 20 and 80 percent of the

stock of the dividend-paying companies are taxed on 20 percent of the dividends. Firms that own more

than 80 percent of another firm’s stock are not taxed on the dividends.

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552Part IVCapital Structure

debt, or equivalently, as using the internally generated capital so that the firm does

not have to take on additional debt.¹³

If Bill Gates prefers that Microsoft use its

retained earnings to invest in debt on his behalf, this debt may just as well be the

firm’s debt as any other source of debt that would ultimately be netted against the

firm’s liabilities.

Given that the tax preference for debt financing versus internal equity financing

depends on the personal tax rates of shareholders, it follows that shareholders with dif-

ferent marginal tax rates may not agree about capital structure policy. This disagree-

ment is illustrated in the following example:

Should Microsoft Increase Its Leverage?

Bill Gates, founder and CEO of Microsoft, recognizes that there is a tax gain from debt

financing and that Microsoft can increase the firm’s leverage, either by repurchasing shares

or by paying a dividend, and funding more of the firm’s investment needs from debt secu-

rities without running any significant risk of bankruptcy. This would increase firm value by

lowering its corporate tax bite.

Gates currently owns about 20 percent of the company’s shares. Assume that he would

like to retain this percentage of ownership. The corporate tax rate is currently 35 percent and

Gates’s personal tax rate is 40 percent on ordinary income and 20 percent on capital gains.

Different shareholders may have different opinions about whether the firm should pay a large

dividend, repurchase shares, or continue with its policy of retaining most of its earnings to

fund its investments internally. For example, tax-exempt institutions definitely would prefer

that the firm repurchase shares or pay a dividend to increase its debt, at least to the point

where there is some risk of bankruptcy. However, Bill Gates may personally prefer keeping

the firm underleveraged. If the firm uses a large dividend to distribute its retained earnings,

Gates will have to pay 40 percent of the distribution in taxes. Because of the lower capital

gains tax, he would prefer a share repurchase over a dividend. However, if Gates is going to

keep his percentage ownership of the firm constant he will have to sell some of his shares,

forcing him to realize the capital gains on his shares. As we showed in the last section, Gates’s

incentive to have Microsoft distribute cash depends on the difference between his personal

rate and Microsoft’s corporate tax rate. If the corporate tax rate is less then the personal rate,

he will prefer retaining the earnings rather than distributing them.

Result 15.6

The combination of the corporate tax deductibility of interest payments and the personaltaxes on dividends (and share repurchases) implies that:

•

The U.S. tax code favors debt financing over financing investments by issuing equity.

•

For taxable shareholders, the tax preference for debt over internally generated equity(that is, retained earnings) is less than the tax preference for debt over newly issuedequity. Indeed, individual investors with sufficiently high personal tax rates have atax preference for financing new investment with retained earnings, rather thanpaying out the earnings and financing new investment with debt.

Consistent with Result 15.6, an in-depth study of large corporations by Gordon

Donaldson (1961) found that managers prefer funding investment, first, with retained

earnings, second, after the supply of retained earnings has been exhausted, with debt, and

finally, when it is imprudent for the firm to borrow additional amounts, by issuing outside

equity. This financing hierarchy is known as the pecking orderof financing choices.¹⁴

¹³As

long as the tax cost associated with distributing capital to shareholders (for example, the capital

gains rate that is triggered by a share repurchase) is constant, the actual rate is irrelevant. However, if the

rate is changing over time, corporations may find it in their interests to optimally time their distribution

choices to correspond to situations where the tax cost of the distribution is minimized.

¹⁴Non-tax-based

explanations for this pecking order behavior are described in Chapters 17 and 19.

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Chapter 15	How Taxes Affect Dividends and Share Repurchases	553
Chapter 15	How Taxes Affect Dividends and Share Repurchases