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 thealty to shareholders if dividends were paid conclusion that no dividends should everby corporations. Why firms paid divi- be distributed, a clearly counterfactualdends in such an environment has been prediction. The primary explanation forone of the most important puzzles in fi- why dividends are paid even though theynance; 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 toent implications for calculating the cost of shareholders about the future prospectscapital and predicting the effects of of the firm (see Bhattacharya (1979),changes in capital gains tax treatment. Mller and Rock (1985), and John andAlmost all the empirical evidence regard- William (1985)). According to this view,ing these explanations looks at firms' div- "the raising and lowering of dividendsidend payout behavior in indirect ways. communicates information [to sharehold-

ers] over and beyond what is provided byThe survey reported here instead asksirms' 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 toof 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 forholds, and also asked whether managers dividends combines asymmetric informa-agreed with various statements regard- tion with agency costs. As explained bying corporate dividend policy. While there Crockett and Friend (1988), "sharehold-are other surveys regarding financial pol- ers are not sufficiently well informed toicy (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." Shareholdersof no others that deal specifically with evaluate managerial behavior very littledividend policy. Our survey attempts to because the information necessary for suchget 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 payoutcisions 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 thethat taxes affect shareholders' optimal best interests of shareholders (see Easter-dividend payout ratios because dividends brook (1984)). Ofer and Thakor (1987) addresult 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

492 NATIONAL TAX JOURNAL (Vol. XLIII

cash disbursement from their shares is were identified from the November 1987through dividends, and they may be will- issue of Business Week. The name of theing to impose a tax cost on other share- company, the name of the CEO, and theholders (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 foundtele 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 moreholders may prefer dividends to capital addresses were found elsewhere. Of thegains 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-

2or no tax advantage to capital gains. The plete.most important group is non-taxable in- The numbers in brackets in Exhibit 1stitutions, 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 showholders are also in the "low-tax clientele." the percentages of respondents choosingThese shareholders will own stock in flrms each option. For question 2 the number

3with high dividend payout ratios while shows the mean response. For questionother shareholders (the "high-tax clien- 3, a full 58 percent of the respondentstele") will invest in firms with low payout claim not to have any idea of who theirratios. 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 nextPettit (1977), Gordon and Brafford (1980), to each option for question 3 are the meanand Scholz (1989). Studies finding contra- responses of the 42 percent of respondentsdictory evidence include Long (1978), who indicated a knowledge of the firm'sLitzenberger and Ramaswamy (1979, shareholders. For example, of the respon-1982), Hess (1982), Auerbach (1983), Po- dents who estimated the fraction of theirterba 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 taxholds that taxes are irrelevant because bracket while an average of 21 percent ofdividend 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 numbersbach (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 respondentsfails to deal adequately with the possibil- ranked each explanation as first in im-ity of periodic share repurchases. There is portance. The second number indicatesalso contradictory empirical evidence (see what percentage ranked each explanationPoterba and Summers (1984)). The con- either first or second in importance. Of thetroversy 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 UnitedStates. The survey contained questions Analysis of the Survey Responsesabout the dividend payout ratio, share-holder demographics, and other factors. The first step in analyzing the resultsThe survey instrument is shown in Ex- was to group the firms into five categorieshibit 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

No. 41 TAXES AND FIRMS'DIVIDEND POLICIES 493

and standard deviation of the respon- To see whether firms' answers regard-4dents' 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 basednormal. Thus few of the respondents had on their responses to question 4 on thepayout 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 variableestimated to be 45 percent. This indicates equalled one if the corresponding expla-that the corporations surveyed may not nation was ranked either first or secondbe representative of the general corporate in importance, and zero otherwise. Thepopulation. dummy variable associated with the view

The survey responses cast doubt on the that shareholders have high marginal taxnotion 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. Theof the firms claim to know who their coefficients on the other dummy variablesshareholders 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 firmcan play a significant role in the deter- that considers the high tax rate/prefermination of the payout ratio; these man- capital gains argument as the only im-agers cannot know whether dividends will portant explanation and the payout ratioresult in large tax liabilities for the firm's of a firm that considers only one of theshareholders, and so cannot be tailoring other explanations as important. Only 12.5dividend 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 ashareholders are, an average of only 25 rank of one or two to the explanation thatpercent of stock is held by "other individ- shareholders prefer retained earnings dueuals," a group assumed to have relatively to high marginal tax rates do have sig-

4high marginal tax rates. If firms' payout nffimntly lower payout ratios than the restratios were determined primarily by of the sample, though, as seen by the highstockholders' tax status, then the small t-ratios on the other dummy variables. Ifpercentage of stockholders facing high this were a firm's only important expla-marginal tax rates would be expected to nation, its predicted payout ratio wouldresult in high average payout ratios in thesample. This is not the case, casting fur-ther doubt on tax-based explanations of TABLE 2dividend 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: 125Coefficient

Explanation Estimate

Constant 15.034TABLE1 (3.24)

PERCENTAGE DISTRIBUTION OF PAYOUT Dividends act as signals 10.772RATIOS (3.86)

Shareholders prefer dividends 14.067Interval % of Firms b/c of low tax rates (2.96)

less than 2% 5 Shareholders prefer dividends 11.2282-17% 7 b/c of non-tax reasons (3.35)

17-32% 34 Availability of worthwhile 6.78632-47% 39 investment projects (1.91)47_62% 11 Other reasons 10.947

at least 62% 3 (2.55)

494 NATIONAL TAX JOURNAL [Vol. XLIII

be 15 percent as seen by the constant term. payout ratio and answers to question 5 ofOther explanations yield increases in the the survey have the predicted signs, theypredicted 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 arecorporations 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 anranking that explanation as first or sec- important factor determining their divi-ond in importance. The signalling theory dend policy. Third, it is clear that mostis also consistent with the statistically firms have payout ratios near the meansignificant coefficient on the signalling value. Third, it is clear that most firmsdummy 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 therethey do not plan to change their payout will be many firms at the extremes of theratios as a result of the Tax Reform Act payout ratio distribution and relatively fewof 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 ofWhile 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. Thiswould have no effect on payout ratios, the is consistent with the tax capitalizationsignalling theory does as well. However, theory's view of dividends as a residualCEOs 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 firmsdollar 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 taxlief. 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 aboutresults. 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, firmssignalling. More indirect evidence is pro- should think that there is no difference invided by looking at the correlations be- terms of effects on share prices betweentween 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 managersthought that dividfft yielded the high- Conclusionsest 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 bytained 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. Butthe correlation coefficients between the such tests have been inconclusive regard-

No. 41 TAXES AND FIRMS'DIVIDEND POLICIES 495

ing the competing theories of corporate dents claimed not to know the tax statusdividend 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 aboutcorporations in the United States to try to whether dividends or retained earningsd 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 wereunambiguous support for any of the four nearly evenly divided among the threeexplanations. When asked to rank possi- choices offered. Eighty-five percent of theble explanations for their dividend pay- respondents expected no change in theirout 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 withsecond. Forty-four percent gave a high most of the theories.rank to an explanation consistent with an The survey results strongly suggest thatagency cost explanation. Thirty-six per- no single theory consistently explains thecent gave a high rank to an explanation behavior o.^all firms. Calculations of theconsistent with the "new" view of taxes cost of capital or the effect of capital gainsand 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 ofholders' tax rates in their top two expla- dividend behavior is correct should benations; a full 58 percent of the respon- viewed with caution. Empirical investi-

Exhibit 1SURVEY OF PAYOUT RATIO BEHAVIOR*

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 payoutratio (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 profitsis 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

496 NATIONAL TAX JOURNAL [Vol. XLIII

gations attempting to identify the single a Tax on CorporateDistributions."Journalof Pub-(,correct" explanation of dividend behav- licEconomics15 (Fib. 1981)1-22.ior are unlikely to succeed, since no sin- Crockett, J. and 1. Friend. "Dividend Policy in Per-

spective: Can Theory Explain Behavior?" Review ofgle explanation is correct for all firms. Economics and Statistics 70 (Nov. 1988) 603-613.

Easterbrook, F. "Two Agency-Cost Explanations ofDividends." American Economic Review 74 (Sept.ENDNOTES 1984) 650-659.

***This paper is based on Abrutyn's undergraduate Esposito, J., ed. Moody's Industrial Handbook ofhonors 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 Payfor 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 Publiclarge number of similar requests received, the firm Economics 14 (Oct. 1980) 109-136.has a general policy against filling out surveys. This Hakansson, N. "To Pay or Not to Pay Dividends."indicates that these non-responding firms do not have Journal of Finance 37 (May 1982) 415-428.a specific common characteristic in their dividend Hess, P. "The Ex-Dividend Day Behavior of Stock Re-policy that would bias the results through their ex- turns: Further Evidence on Tax Effects." Journalclusion. Other surveys were returned blank except for of Finance 37 (May 1982) 445-456.an indicated payout ratio of zero. Since the survey re- John K. and J. Williams. "Dividends, Dilution and

vesti- -;es: A Signalling Equillibrium." Journal of Fi-sponses were anonymous, it is impossible to inis

gate fully the characteristics of those firms which did nance 40 (Sept. 1985) 1053-1070.not returm complete responses. King, M. Public Policy and the Corporation (Undon:

'Thm mean is based on the complete responses. Many Chapman and Hall, 1977).of the incomplete surveys indicated a payout ratio of Lintner, J. "Distribution of Incomes of Corporationszero. Adding these to the sample yields a mean pay- Among Dividends, Retained Earnings and Taxes."out ratio of 2fl.9 percent. American Economic Review 46 (May 1956) 97-113.

4jt is assumed that little stock is owned by individ_ Litzenberger, R. and K. Ramaswamy. "The Effect ofuals whose taxable income is low enough that they Personal Taxes and Dividends on Capital Assetface a marginal tax rate of zero. Priem. Theory and Empirical Evidence." Journal of

'Regressions using dummy variables representing Financial Economics 7 (June 1979) 163-195.whether each explanation was listed as first in im- Litzenberger, R. and K. Ramaswamy. "The Effects ofportance had virtually - predictive power. Dividends on Common Stock Prices: Tax Effects or

Information Effects?" Journal of Finance 37 (May1982) 429-443.

REFERENCES Long, J. "The Market Valuation of Cash Dividends:A Case to Consider." Journal of Financial Econom-

Ambarish, R. et al. "Efficient Signaling with Divi- ics 6 (June/Sept. 1978) 236-264.dends and Investments." Journal of Finance 42 (June Miller, M. and K. Rock. "Dividend Policy Under1987) 321-343. Asymmetric Information." Journal of Finance 40

Auerbach, A. "Wealth Maximization and the Cost of (Sept. 1985) 1031-1051.Capital." Quarterly Journal of Economics 93 (Au- Miller, M. and M. Scholes. "Dividends and Taxes: Somegust 1979) 433-446. Empirical Evidence." Journal of Political Economy

Auerbach, A. "Stockholder Tax Rates and Firm At- 90 (Dec. 1982) 1118-1141.tributes." Journal ofPubli4cEconomics 21 (July 1983) Ofer, A. and A. Thakor. "A Theory of Stock Price Re-107-127. sponses to Alternative Corporate Cash Disburse-

Baker, H. K., G. FarreUy and R. Edelman. "A Survey ment Methods: Stock Repurchases and Dividends."of Management Views on Dividend Policy." Finan- Journal of Finance 42 (June 1987) 365-394.cW Management 14 (Autumn 1985) 78-84. Pettit, R. "Taxes, Transactions Costs and the Clien-

Bhattacharya, S. "Imperfect Information, Dividend tele Effect of Dividends." Journal of Financial Eco-Policy, and the Bird in the Hand Fallacy." Bell nomics 5 (Dec. 1977) 419-436.Journal of Economics 10 (Spring 1979) 259-270. Poterba, J. "Tax Policy and Corporate Savings."

Black, F. "The Dividend Puzzle." Journal of Portfolio Brookings Papers onEconomic Activity (1987:2) 455-Management 2 (Winter 1976) 5-8. 515.

Black, F. and M. Beholes. "The Effects of Dividend PoWtba, J. and L. Summers. "New Evidence ThatPolicy and Dividend Yield on Common Stock Prices Taxes Affect the Valuation of a Dividend." Journaland Returns." Journal of Financial Economics 1 of Finance 39 (Dec. 1984) 1397-1415.(May 1974) 1-22. Scholz, J. K. "The Effect of the Relative Tax Treat-

Blume, M. and I. Friend. "Institutions in NASDAQ: ment of Dividends and Capital Gains on Aspects ofA Rapidly-Growing Presence." The NASDAQ Corporate and Individual Behavior." Proceedings ofHandbook (Chicago: Probus Publishing Company, the Eighty-First Annual Conference. 1988 (Colum-1987). bus, OH: National Tax Association-Tax Institute of

Bradford, D. "The Incidence and Allocation Effects of America; 1989) 114-120.