Chapter 16 Payout Policy 423
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By shifting their distribution policies in this way, corporations can transmute dividends
into capital gains. If this financial alchemy results in lower taxes, it should be welcomed by
any taxpaying investor. That is the basic point made by the leftist party when it argues for
repurchases instead of dividends.
There is no doubt that taxes on dividends can make a difference. The leftists quickly run
into two problems, however. First, if they are right, why should any firm ever pay a cash divi-
dend? If cash is paid out, repurchases should always be the best channel as long as the firm
has taxable shareholders.^20 Second, the difference in the tax rate has now disappeared for
both are taxed at 23.8%.^21 However, capital gains still offer some tax advantage, even at these
low rates. Taxes on dividends have to be paid immediately, but taxes on capital gains can be
deferred until shares are sold and gains realized. The longer investors wait to sell, the lower
the PV of their tax liability.^22
The distinction between dividends and capital gains is not important for many financial
institutions, which operate free of all taxes. For example, pension funds are not taxed. These
funds hold $5.3 billion of common stocks, so their clout in the U.S. stock market is enormous.
Only corporations have a tax reason to prefer cash dividends. They pay corporate income tax
on only 30% of dividends received. Thus the effective tax rate is 30% of 35% (the marginal
corporate rate), or 10.5%. But corporations have to pay 35% tax on the full amount of realized
capital gains.
The low-payout party has nevertheless maintained that the market rewards firms that have
low-payout policies. They have claimed that firms that paid dividends and as a result had to
issue shares from time to time were making a serious mistake. Any such firm was essentially
financing its dividends by issuing stock; it should have cut its dividends at least to the point at
which stock issues were unnecessary. This would not only have saved taxes for shareholders
but it would also have avoided the transaction costs of the stock issues.^23
Empirical Evidence on Dividends and Taxes
It is hard to deny that taxes are important to investors. You can see that in the bond market.
Interest on municipal bonds is not taxed, and so municipals have often sold at low pretax
yields. Interest on federal government bonds is taxed, and so these bonds have sold at higher
pretax yields. It does not seem likely that investors in bonds just forget about taxes when they
enter the stock market.
There is some evidence that in the past taxes have affected U.S. investors’ choice of
stocks.^24 Lightly taxed institutional investors have tended to hold high-yield stocks and
retail investors have preferred low-yield stocks. Moreover, this preference for low-yield
BEYOND THE PAGEmhhe.com/brealey12eU.S. tax rates(^20) A firm that eliminates dividends and makes regular repurchases may find that the Internal Revenue Service interprets the repur-
chases as de facto dividends and taxes the payout accordingly. However, in practice this tax risk is a threat only for privately held
firms. Nevertheless, public corporations do not usually announce that they are repurchasing shares to save investor taxes on dividends.
They may say, “Our stock is a good investment” or “We want to have shares available to finance possible future acquisitions.” What
do you think of these rationales?
(^21) These rates are composed of a basic 20% rate plus a net investment income surtax of 3.8% for investors in the highest tax brackets.
(^22) When securities are sold, capital gains tax is paid on the difference between the selling price and the purchase price or basis. Shares
purchased in 2009 for $20 (the basis) and sold in 2014 for $30 would generate a capital gain of $10 per share and a tax of $2.38 at a
23.8% rate.
Suppose sale is deferred one year to 2015. If the interest rate is 5%, the PV of the tax, viewed from 2014, falls to 2.38/1.05 = $2.27.
The effective capital gains tax rate is 22.7%. The longer sale is deferred, the lower the effective tax rate.
The effective tax rate falls to zero if the investor dies before selling because under current U.S. estate-tax law, his or her heirs get
to “step up” the basis without realizing a taxable gain. Suppose the price is still $30 when the investor dies. The heirs could sell for
$30 and pay no tax because they could step up to a $30 basis. The investor’s stock holdings may be subject to estate taxes, however.
(^23) These costs can be substantial. Refer to Chapter 15, especially Figure 15.5.
(^24) See, for example, Y. Grinstein and R. Michaely, “Institutional Holdings and Payout Policy,” Journal of Finance 60 (June 2005),
pp. 1389–1426; and J. R. Graham and A. Kumar, “Do Dividend Clienteles Exist? Evidence on Dividend Preferences of Retail Inves-
tors,” Journal of Finance 61 (June 2006), pp. 1305–1336.