taxes and divedends

1. TAXES AND FIRMS'DIVIDEND POLICIES: SURVEY RESULTS
STEPHANM ABRUTYN* AND ROBERT W. TURNER**
Introduction shareholders, while if the funds are re-
tained by-the firm, they result in capital
RIOR to the Tax Reform Act of 1986
gains which receive prefir@ntia-l-tax
Pthere appeared to be a large tax pen- treatment. This argument leads to the
alty to shareholders if dividends were paid conclusion that no dividends should ever
by corporations. Why firms paid divi- be distributed, a clearly counterfactual
dends in such an environment has been prediction. The primary explanation for
one of the most important puzzles in fi- why dividends are paid even though they
nance; there are at least four distinct ex- lead to higher tax liabilities for share-
planations in the literature, with differ- holders is that dividends send a signal to
ent implications for calculating the cost of shareholders about the future prospects
capital and predicting the effects of of the firm (see Bhattacharya (1979),
changes in capital gains tax treatment. Mller and Rock (1985), and John and
Almost all the empirical evidence regard- William (1985)). According to this view,
ing these explanations looks at firms' div- "the raising and lowering of dividends
idend payout behavior in indirect ways. communicates information [to sharehold-
ers] over and beyond what is provided by
The survey reported here instead asks
irms' managers inquestions directly of f
earnings reports, forecasts, and other an-
an attempt to identify the motives under- nouncements" (Hakansson (1982), p. 415).
lying their payout behavior. A major drawback to this explanation,
There have been a few other surveysi however, is that no one has been able to
of corporate financial policy, dating back determine why dividends are better sig-
at least to Lintnees (1956) study of divi- nals than other, less costly alternatives.
dend policy which resulted in his oft-cited It is also not clear that the signals divi-
finding that firms tried to maintain a dends send about the firm's expected re-
steady dividend rate. A recent survey turn are unambiguous (see Black and
(Baker, Farrelly, and Edehnan (1985)) had Scholes (1974), Black (1976), and Ambar-
as its major objective to see if Lintner's ish et al. (1987)).
behavioral model of dividend policy still A second "old view" explanation for
holds, and also asked whether managers dividends combines asymmetric informa-
agreed with various statements regard- tion with agency costs. As explained by
ing corporate dividend policy. While there Crockett and Friend (1988), "sharehold-
are other surveys regarding financial pol- ers are not sufficiently well informed to
icy (see the series of articles in recent is- know whether or not management is act-
sues of Financial Management) we know ing in their best interests." Shareholders
of no others that deal specifically with evaluate managerial behavior very little
dividend policy. Our survey attempts to because the information necessary for such
get direct evidence of the importance of evaluation is costly to obtain. If share-
tax factors in firms' dividend payout de- holders demand a high dividend payout
cisions and to distinguish between com- then managers must generate funds ex-
peting theories of how taxes affect divi- temally. If the firm remains in the mar-
dends. ket for new capital, market mechanisms
The "old vieme'of dividend taxation holds ensure that managers are acting in the
that taxes affect shareholders' optimal best interests of shareholders (see Easter-
dividend payout ratios because dividends brook (1984)). Ofer and Thakor (1987) add
result in an immediate tax liability for that, if managers are shareholders, they
personally prefer dividends to share re-
*University of Pennsylvania Law School, Philadel-
purchases since most companies forbid
Phia, PA 19103. managers from tendering their shares.
**Colgate University, Hwnilton, NY 13323. Thus, the only way managers can get a
491
National Tax Journal, Vol. 43, no. 4,
(December, 1990), pp. 491-96

2. 492 NATIONAL TAX JOURNAL (Vol. XLIII
cash disbursement from their shares is were identified from the November 1987
through dividends, and they may be will- issue of Business Week. The name of the
ing to impose a tax cost on other share- company, the name of the CEO, and the
holders (and themselves) to get the cash. city in which the corporate headquarters
Perhaps the most widely tested expla- is located were all listed in the magazine.
nation of dividends is known as the clien- Specific addresses and zip codes were found
tele hypothesis (see Gordon and Brafford in Moody's Handbook (Esposito (1987)) for
(1980)). Some important groups of share- almost 550 of the companies; a few more
holders may prefer dividends to capital addresses were found elsewhere. Of the
gains because dividends provide cash flow 550 surveys sent out, 208 were returned.
and, for these shareholders, there is little 163 of the returned surveys were com-
2
or no tax advantage to capital gains. The plete.
most important group is non-taxable in- The numbers in brackets in Exhibit 1
stitutions, but individuals with low mar- show the results of the survey. For ques-
ginal tax rates and other corporate share- tions 1 and 5 the numbers in brackets show
holders are also in the "low-tax clientele." the percentages of respondents choosing
These shareholders will own stock in flrms each option. For question 2 the number
3
with high dividend payout ratios while shows the mean response. For question
other shareholders (the "high-tax clien- 3, a full 58 percent of the respondents
tele") will invest in firms with low payout claim not to have any idea of who their
ratios. Empirical evidence regarding the shareholders are; they had all 100 per-
clientele hypothesis has been mixed. cent of their stock in the "don't know"
Studies that find clientele effects include category. The numbers in brackets next
Pettit (1977), Gordon and Brafford (1980), to each option for question 3 are the mean
and Scholz (1989). Studies finding contra- responses of the 42 percent of respondents
dictory evidence include Long (1978), who indicated a knowledge of the firm's
Litzenberger and Ramaswamy (1979, shareholders. For example, of the respon-
1982), Hess (1982), Auerbach (1983), Po- dents who estimated the fraction of their
terba and Summers (1984), Poterba (1987), shareholders in each of the listed groups,
and Blume and Friend (1987). an average of 5 percent of the stock is held
The "new view" of dividend taxation by individuals in the 15 percent tax
holds that taxes are irrelevant because bracket while an average of 21 percent of
dividend taxes get capitalized into the the stock is held by unknown sharehold-
value of the firm (see King (1977), Auer- ers. For question 4 there are two numbers
bach (1979), and Brafford (1981)). The separated by a slash. The first number re-
major drawback to this theory is that it lates what percentage of the respondents
fails to deal adequately with the possibil- ranked each explanation as first in im-
ity of periodic share repurchases. There is portance. The second number indicates
also contradictory empirical evidence (see what percentage ranked each explanation
Poterba and Summers (1984)). The con- either first or second in importance. Of the
troversy between the "old view" and "new 18 percent who indicated that an expla-
view') continues to be the main focus of nation other than those listed was impor-
research on dividend taxation. tant, no two gave the same alternative.
This indicates that many firms pay divi-
The Survey
dends for reasons unique to that firm.
None of the proposed theories of dividend
In 1988 a survey was sent to the chief behavior are likely to explain their be-
executive offiem (CEOs) of 550 of the havior.
biggest 1000 corporations in the United
States. The survey contained questions
Analysis of the Survey Responses
about the dividend payout ratio, share-
holder demographics, and other factors. The first step in analyzing the results
The survey instrument is shown in Ex- was to group the firms into five categories
hibit 1. The numbers in brackets are dis- based on their payout ratios. The inter-
cussed below. The top 1000 corporations vals were chosen on the basis of the mean
National Tax Journal, Vol. 43, no. 4,
(December, 1990), pp. 491-96

3. No. 41 TAXES AND FIRMS'DIVIDEND POLICIES 493
and standard deviation of the respon- To see whether firms' answers regard-
4
dents' payout ratios. Table 1 shows the ing the determinants of their dividend
intervals and the percentage of compa- policy explain their actual payout ratios,
nies falling in each interval. The distri- firms' reported payout ratios were re-
bution of payout ratios is approximately gressed on a set of dummy variables based
normal. Thus few of the respondents had on their responses to question 4 on the
payout ratios as high as the- l@iidugtff-av- suiVe-y.- Tti6 -rerr6sgion-" results are re-
erage, which Feldstein and Green (1983) ported in Table 2. Each dummy variable
estimated to be 45 percent. This indicates equalled one if the corresponding expla-
that the corporations surveyed may not nation was ranked either first or second
be representative of the general corporate in importance, and zero otherwise. The
population. dummy variable associated with the view
The survey responses cast doubt on the that shareholders have high marginal tax
notion that dividend policy is based on rates and therefore prefer retained earn-
shareholders' tax rates. Only 42 percent ings was left out of the regression. The
of the firms claim to know who their coefficients on the other dummy variables
shareholders are. If these claims are to be therefore measure the estimated differ-
believed, it is hard to see how the tax laws ence between the payout ratio of a firm
can play a significant role in the deter- that considers the high tax rate/prefer
mination of the payout ratio; these man- capital gains argument as the only im-
agers cannot know whether dividends will portant explanation and the payout ratio
result in large tax liabilities for the firm's of a firm that considers only one of the
shareholders, and so cannot be tailoring other explanations as important. Only 12.5
dividend policy to their shareholders' tax percent of the variation in the payout ra-
status. tio can be explained by the set of inde-
Of the firms that know who their pendent variables."fhe firms who gave a
shareholders are, an average of only 25 rank of one or two to the explanation that
percent of stock is held by "other individ- shareholders prefer retained earnings due
uals," a group assumed to have relatively to high marginal tax rates do have sig-
4
high marginal tax rates. If firms' payout nffimntly lower payout ratios than the rest
ratios were determined primarily by of the sample, though, as seen by the high
stockholders' tax status, then the small t-ratios on the other dummy variables. If
percentage of stockholders facing high this were a firm's only important expla-
marginal tax rates would be expected to nation, its predicted payout ratio would
result in high average payout ratios in the
sample. This is not the case, casting fur-
ther doubt on tax-based explanations of TABLE 2
dividend policy. ORDINARY LEAST SQUARES REGRESSION
Finally, only two of the suggested re- RESULTS
sponses to question 4 of the survey entail (T-Ratios in Parentheses)
taxes. Just 18 percent of the firms listed Dependent Variable: Payout Ratio
either of these two as important expla-
Mean Payout Ratio: 32.4
nations of their dividend policy. R-Squared: 125
Coefficient
Explanation Estimate
Constant 15.034
TABLE1 (3.24)
PERCENTAGE DISTRIBUTION OF PAYOUT Dividends act as signals 10.772
RATIOS (3.86)
Shareholders prefer dividends 14.067
Interval % of Firms
b/c of low tax rates (2.96)
less than 2% 5 Shareholders prefer dividends 11.228
2-17% 7 b/c of non-tax reasons (3.35)
17-32% 34 Availability of worthwhile 6.786
32-47% 39 investment projects (1.91)
47_62% 11 Other reasons 10.947
at least 62% 3 (2.55)
National Tax Journal, Vol. 43, no. 4,
(December, 1990), pp. 491-96

4. 494 NATIONAL TAX JOURNAL [Vol. XLIII
be 15 percent as seen by the constant term. payout ratio and answers to question 5 of
Other explanations yield increases in the the survey have the predicted signs, they
predicted payout ratio of between 7 and are both less than .15 in absolute value.
14 percent. The survey results contain three pieces
of evidence damaging to the clientele hy-
Implications for Theories pothesis. First, the fact that so few of the
The survey results have a number of firms know the tax status of their share-
implications for the various theories of why holders makes it unlikely that firms are
corporations pay dividends. The theory tailoring their dividend policy to any par-
that dividends are paid out because they ticular tax clientele. Second, only 18 per-
serve as a signal to shareholders is sup- cent of the firms indicated that the mar-
ported by the 63 percent of respondents ginal tax rates of shareholders was an
ranking that explanation as first or sec- important factor determining their divi-
ond in importance. The signalling theory dend policy. Third, it is clear that most
is also consistent with the statistically firms have payout ratios near the mean
significant coefficient on the signalling value. Third, it is clear that most firms
dummy variable in Table 2 and the 85 have payout ratios near the mean value.
percent of respondents who stated that The clientele hypothesis predicts that there
they do not plan to change their payout will be many firms at the extremes of the
ratios as a result of the Tax Reform Act payout ratio distribution and relatively few
of 1986. The regression coefficient indi- in the intermediate range.
cates that the fims who think signalling The tax capitalization view also re-
is important have significantly higher ceives some support from the survey re-
payout ratios than firms who believe their sults. Thirty-six percent of the respon-
shareholders prefer retained earnings. dents claimed that the availability of
While other explanations would also lead worthwile investment projects was an im-
to the prediction that the Tax Reform Act portant factor in their dividend policy. This
would have no effect on payout ratios, the is consistent with the tax capitalization
signalling theory does as well. However, theory's view of dividends as a residual
CEOs who believe in signalling should also after the firms finance profitable invest-
believe that a dollar of dividends will bring ment projects out of their after-tax prof-
about a higher rise in share price than a its. The fact that 58 percent of the firms
dollar of retained earnings. Only 21 per- do not know the tax status of their share-
cent of all CEOs claimed to hold this be- holders is also consistent with the tax
lief. capitalization view, since the tax status of
Agency cost explanations for dividends a fir&s current shareholders is irrele-
also receive some support from the survey vant. But the most direct evidence about
results. About 44 percent of the respon- the tax capitalization hypothesis is pro-
dents indicated that shareholders prefer vided by answers to question 5 of the sur-
dividends for non-tax reasons other than vey. If the hypothesis is correct, firms
signalling. More indirect evidence is pro- should think that there is no difference in
vided by looking at the correlations be- terms of effects on share prices between
tween firinspayout ratios and managers' paying dividends and retaining earnings.
views on whether dividends or retained While more respondents chose this an-
earnings increase share prices by more. If swer than either of the others, the per-
managers were acting in shareholders' centage of respondents was only 40.
interests, then firms whose managers
thought that dividfft yielded the high- Conclusions
est increase in share price would be ex- Economists are hesitant to pay atten-
pected to have high payout ratios, while tion to the reasons firms give for their ac-
firms whose managers thought that re- tions. Theories are most often tested by
tained earnings were more valuable to the observing how the firms respond to ex-
firm should have low payout ratios. While ogenous changes in their environment. But
the correlation coefficients between the such tests have been inconclusive regard-
National Tax Journal, Vol. 43, no. 4,
(December, 1990), pp. 491-96

5. No. 41 TAXES AND FIRMS'DIVIDEND POLICIES 495
ing the competing theories of corporate dents claimed not to know the tax status
dividend payout behavior. In this note a of their shareholders. Thus the tax clien-
more direct approach is taken. tele hypothesis received the weakest sup-
Surveys were sent to the Chief Execu- port.
tive Officers of 550 of the biggest 1000 Firms' answers to a question about
corporations in the United States to try to whether dividends or retained earnings
d nguis among our
C,--
- 1'4U -t@ hiki@ - - -*@re fnd-@@- *isti @'-h -- --fo@ om@eeiiig e@cp - leicct ei'ghhre pii6i6s onsis-
nations of why firms pay dividends. The tent with any of the proposed explana-
163 complete responses do not provide tions of dividend policy. The answers were
unambiguous support for any of the four nearly evenly divided among the three
explanations. When asked to rank possi- choices offered. Eighty-five percent of the
ble explanations for their dividend pay- respondents expected no change in their
out ratio, 63 percent of the firms ranked dividend payout ratio due to the Tax Re-
a signalling explanation either first or form Act of 1986, a result consistent with
second. Forty-four percent gave a high most of the theories.
rank to an explanation consistent with an The survey results strongly suggest that
agency cost explanation. Thirty-six per- no single theory consistently explains the
cent gave a high rank to an explanation behavior o.^all firms. Calculations of the
consistent with the "new" view of taxes cost of capital or the effect of capital gains
and dividends. Only 18 percent of the firms tax changes that are based on an as-
included any explanation based on share- sumption that one particular theory of
holders' tax rates in their top two expla- dividend behavior is correct should be
nations; a full 58 percent of the respon- viewed with caution. Empirical investi-
Exhibit 1
SURVEY OF PAYOUT RATIOBEHAVIOR*
1. What effect do you think the Tax Reform Act of 1986 will have on your firiwa dividend payout ratio?
[51 ---Retain a higher percentage of after-tax profits
[ill ay out a higher percentage of after-tax profits as dividends
[851----No effect
2. What is your firies current payout ratio?@-[32.4%]
3. What percentage of your fir&s stock is owned by the following?
[51 Individuals who would fall into the 15% tax bracket for 1988
[251 -Other individuals
[371----Non-taxable institutions
[131 -Other corporations
[211 on't know [58% of firms put all their stock in this category]
4. Please rank the following according to their importance in your firm's decision as to size of the payout
ratio (if not considered, leave blank).
[27/631 A belief that shareholders view dividends as a signal of the firnfs financial strength
[3/9) A belief that, because of their relatively high marginal tax rates, shareholders prefer that the
corporation retain earnings
[4/91 A belief that, because of their relatively low marginal tax rates, shareholders prefer dividends
[25/36] -The availability of worthwhile investment projects
(26/441 A belief that shareholders, for reasons other than the tax laws, prefer dividends (or retained
earnings)
[16/181 -Other (please specify)
5. Do you think that the share price of your firriys stock will increase more if a dollar of after-tax profits
is retained by the firm or if the dollar is paid out to shareholders in the form of a dividend?
[391 ----retained by the firm
[211 -paid out as a dividend
[401 ---no difference between the two
*Numbers in brackets are discussed in the text
National Tax Journal, Vol. 43, no. 4,
(December, 1990), pp. 491-96

6. 496 NATIONAL TAX JOURNAL [Vol. XLIII
gations attempting to identify the single aTax onCorporateDistributions."JournalofPub-
(,correct" explanation of dividend behav- licEconomics15(Fib. 1981)1-22.
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Crockett, J. and 1. Friend. "Dividend Policy in Per-
spective: Can Theory Explain Behavior?" Review of
gle explanation is correct for all firms. Economics and Statistics 70 (Nov. 1988) 603-613.
Easterbrook, F. "Two Agency-Cost Explanations of
Dividends." American Economic Review 74 (Sept.ENDNOTES 1984) 650-659.
***This paper is based on Abrutyn's undergraduate Esposito, J., ed. Moody's Industrial Handbook of
honors project in economics at Colgate University. The Common Stocks, Summer 1987 (NY: Mwdy's In-
comments of two anonymous reviewers have greatly dustrial Service Service, 1987).
improved the paper. The authors retain responsibility Feldstein, M. and J. Green. "Why Do Companies Pay
for any remaining errors. Dividends?" American Economic Review 73 (March
'We are indebted to an anonymous referee for tell- 1983) 17-30.
ini us of this literature. Gordon, R. and D. Bradford. "Taxation and the Stock
A number of surveys were returned completely Market Valuation of Capital Gains and Dividends:
blank accompanied by a letter stating that, due to the Theory and Empirical Results." Journal of Public
large number of similar requests received, the firm Economics 14 (Oct. 1980) 109-136.
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is
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'Thm mean is based on the complete responses. Many Chapman and Hall, 1977).
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4jt
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Information Effects?" Journal of Finance 37 (May
1982) 429-443.
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National Tax Journal, Vol. 43, no. 4,
(December, 1990), pp. 491-96