Income Taxes and Dividend Policy

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INCOME TAXES AND DIVIDEND POLICY

The income taxes of stockholders should affect the dividend policy of a firm. To help you understand these tax implications, we shall first examine the importance of tax deferral and then show the impact of having two different tax rates, one for ordinary income and one for capital gains. Rational stockholders should value a stock based on the after-tax returns they expect to receive from owning it. The tax status of the return depends on the form in which it is received. For a high-tax stockholder, the marginal tax rate on such income can be high when both state and federal income taxes are considered. High-tax individuals are the beneficial owners of a large fraction of all stock outstanding, but the stock may be owned indirectly through mutual funds or trusts. The returns received by pension funds and by other nontaxable entities are not subject to either ordinary income or capital gains taxes. Payments made by the pension funds to pensioners may be taxable to the pensioner, but the amount of the tax on the distribution will not depend on whether the pension fund received its return in the form of dividends or capital gains. Thus, managers of pension funds can and should value stocks based on the before-tax returns they expect to receive from them. The provisions of the U.S. tax code tend to lead to high-tax individuals preferring stocks whose returns are in the form of capital gains, among other securities with similar risks and characteristics. Also, by comparative advantage, pension fund holders should find that they can do better by holding stocks whose returns are in the form of dividends. There is some evidence that this occurs in practice. For example,

Tax Deferral Advantage
Consider the effect on the stockholders ‘wealth at the end of one period if a company, instead of paying D dollars of dividends, retains and reinvests D to earn a return of r after corporate taxes and then pays a cash dividend of D(1+r) at...
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