Investor protection, taxation, and dividends

Journal of Corporate Finance 18 (2012) 745–762

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Investor protection, taxation, and dividends☆ Mohammed Alzahrani a, 1, Meziane Lasfer b,⁎ a b

King Fahd University of Petroleum & Minerals, Dhahran 31261, Saudi Arabia Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, United Kingdom

a r t i c l e

i n f o

Article history: Received 25 April 2012 Received in revised form 31 May 2012 Accepted 5 June 2012 Available online 13 June 2012 JEL Classification: G18 G35 H24

a b s t r a c t We test the impact of taxes and governance systems on dividend payouts across countries. We show that, unlike previous studies, firms in strong investor protection countries pay lower cash dividends than in weak protection countries when the classical tax system is implemented, but they repurchase more shares to maximise their shareholders' after-tax returns. In weak protection countries, cash dividends and repurchases are low and less responsive to taxes. Our results suggest that when investors are protected, they weigh the tax cost of dividends against the benefit of mitigating the agency cost, but, when they are not, they accept whatever dividends they can extract, even when this entails high tax costs. Crown Copyright © 2012 Published by Elsevier B.V. All rights reserved.

Keywords: Shareholder rights Dividend policy Dividend taxation Agency costs

1. Introduction Previous studies identified the level of investor protection as the primary determinant of the cross-country differences in dividend payments. In strong investor protection countries, shareholders are able to use their power to make managers disgorge cash. However, in countries with poor investor protection, undistributed excess cash is easily appropriated by controlling shareholders for their own private benefits (see La Porta et al., 2000a, for a review), and thus, investors welcome as much dividends as possible (La Porta et al., 2000b), and they assign them a higher value (Kalcheva and Lins, 2007; Pinkowitz et al., 2006). These arguments are based on La Porta et al. (2000b) who develop two distinct models of dividends: The outcome model where dividends emanate from a legal protection of minority shareholders and the substitute model where dividends substitute for weak shareholder protection. Their empirical results support the outcome model, suggesting that better shareholder protection forces managers to payout more dividends, and thus prevents them from gaining private benefits from excess cash flows. Subsequent studies confirm these findings under different specifications. 2

☆ We would like to thank Mara Faccio, Ashraf Eid, Lubomir Litov, Laura Moreau, and Jungwon Suh, Huai Zhang for the useful suggestions. We also benefited from comments offered by seminar participants at Western Finance Association meetings, European Financial Management Association meetings, Asian Finance Association meetings, Financial Management Association meetings, Cass Business School, King Fahd University, Eastern Mediterranean University, Roma Tre University, and Universite Paris Dauphine. This work started when Alzahrani visited Cass Business School. He thanks Cass for the hospitality and support and acknowledges the summer research grant from the British Council and the support from King Fahd University of Petroleum & Minerals. ⁎ Corresponding author. Tel + 44 207 040 8634; fax: + 44 207 040 8881. E-mail addresses: [email protected] (M. Alzahrani), [email protected] (M. Lasfer). 1 Tel.: + 966 3 860 1626; fax: + 966 3 860 2585. 2 See, for example, Faccio et al. (2001), Mitton (2004), Brockman and Unlu (2009), and Shao et al. (forthcoming). 0929-1199/$ – see front matter. Crown Copyright © 2012 Published by Elsevier B.V. All rights reserved. doi:10.1016/j.jcorpfin.2012.06.003

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Do these results hold in the presence of taxes? Pinkowitz et al. (2006) argue that the introduction of taxation complicates the La Porta et al. (2000b) arguments, as when dividends are tax disadvantaged, their value for minority shareholders is reduced, and shareholders in countries with poor investor protection will gain from dividends only in the absence of taxes, or when the gains from preventing expropriation of minority shareholders more than offset the tax disadvantage of dividends. Despite their theoretical importance, the empirical evidence provided to-date on the impact of taxes on dividends at country and firm level is mixed. 3 In this paper, we contribute to the literature by assessing whether firms' payout policy is affected by both governance and taxation. More specifically, we ask the following questions: Do firms in strong investor protection countries pay dividends when their tax cost is high, or do they substitute them for share repurchases to maximise shareholders' after‐tax returns? Conversely, in weak investor protection countries, do firms refrain from paying dividends because of tax costs, do investors fight against controlling shareholders' expropriation of private benefits and accept the more tax efficient repurchases, or do they deem taxation irrelevant and prefer to receive dividends, even if they incur high tax cost? We use a sample that spans 24 OECD countries and 8 years to answer these questions. We classify our countries into strong and weak governance systems, following Djankov et al. (2008), and into tax groups based on the tax differential ratio, defined as the ratio of after-tax dividends to after-tax capital gains, to measure the tax advantages of dividends relative to capital gains; and on the dividend tax system at corporate level. Some countries, such as the US, follow a classical tax system that treats corporate income differently from personal income in terms of statutory tax rate and deduction rules, and taxes earnings paid as dividend twice, first at firm level and then at the personal level; a disadvantage known as “double taxation”. Other countries have a partial imputation system which mitigates some of the tax disadvantages of dividends by crediting part of paid corporate taxes against personal taxes on distributed earnings, or a full imputation system, where dividends are, like interest, fully tax deductible because corporate taxes are fully credited against the personal taxes paid on the distributed earnings. We find strong evidence that both taxation and governance explain dividend payments. More specifically, consistent with the outcome hypothesis and in line with previous studies (e.g., Brockman and Unlu, 2009; La Porta et al., 2000b), we find that cash dividends, and also share repurchases, which were not considered in previous studies because of their unpopularity before 2000, are significantly higher in strong protection countries. However, our investigation extends beyond simply checking the robustness of previous findings by including share repurchases and using a sample from a different period. We also expand the literature by addressing the impact of taxation on payouts, a factor that is not extensively covered in previous studies. In particular, we assess whether companies in strong investor protection countries choose a tax efficient method of returning cash to their shareholders. We, thus, examine the role and nature of taxation in prompting firms to pay dividends and to choose between cash dividends and repurchases. We find that cash dividend payouts are higher in strong investor protection countries only when dividend tax cost is small. In particular, we show that within these countries, dividend payouts, and the gap in total payout between strong and weak protection countries decrease with dividend taxation, and when the classical tax system is in operation, firms pay significantly lower dividends, but they buyback more shares, than their counterparts in weak protection countries. Overall, these results suggest that taxation and governance are interrelated. They imply that in strong investor protection countries investors settle for fewer dividends as the tax cost of dividends is higher than the benefit of reducing the agency cost, but managers maximise their shareholders' after‐tax return by substituting cash dividends for repurchases, while in weak protection countries, taxation plays a limited role and dividends and repurchases are low, suggesting that managers set their dividend policy with no consideration of the tax disadvantage attached to the payout, and investors do not mind this tax cost as long as they can extract cash from the managers. While the focus of our paper is on empirically testing whether governance and taxes affect jointly dividends across countries, we also control in our regressions for a richer set of other determinants of dividends, including, signalling, clientele, catering, and residual theories of dividends. Our results show strong tax and governance effects on both the total payout (dividends and share repurchases) and on cash dividends and share repurchases separately, even after accounting for the specific firm and country fundamentals. 4 In particular, while the relationship between governance and both cash dividends and share repurchases is positive and significant, we report strong evidence that cash dividends are higher and share repurchases are lower when firms operate in full and partial imputation systems and when the tax differential ratio between dividends and capital gains is high. We use various methods, together with different statistical specifications, to separate the taxation impact from governance impact. First, we split our sample into strong and weak governance systems. We find strong effects of both the tax system and the tax differential ratio on cash dividends and share repurchases for firms in strong investor protection countries. However, in weak investor protection countries the tax effect is weak. Interestingly, we find that in strong investor protection countries, firms that repurchase their shares are less likely to pay cash dividends, while in weak investor protection countries cash dividends and share repurchases are not substitutes, suggesting that in these countries managers are less likely to set their dividend policy to maximise their shareholders' after‐tax return. Therefore, previous findings that dividends and repurchases are substitutes documented, amongst others, by Grullon and Michaely (2002) are likely to depend on the governance system of the country analysed.

3 See Pinkowitz et al. (2006), and La Porta et al. (2000a, 2000b) for cross-country evidence and surveys of Allen and Michaely (2003), DeAngelo et al. (2008) and Graham (2008) for predominantly firm level studies. We review some evidence in the next section. 4 Firms across investor protection countries are not homogenous. For example, firms in weak investor protection countries are likely to be more risky (e.g., Ellul et al., 2009), thus, they may pay low dividends and hold cash to weather potential shocks.

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We also assess the separate effect of governance and taxation on dividends by including an interaction variable between governance and imputation system. We find that this variable is positive (negative) and significant for cash dividends (share repurchases), and, interestingly, the governance variable becomes insignificant. These results support the arguments that firms do not pay high cash dividends because of high investor protection only, but their decision to pay dividends or repurchase shares is driven by the combination of taxes and investor protection. We also analyse this effect by using an interaction variable between the tax differential ratio and governance. Although we show that this variable is positive and significant when we use industryadjusted data with country random effects in our cash dividend regression, its impact is weak when we analyse share repurchases and when we use Tobit model with country random effect. This is partly due to the difficulties in estimating the personal income and capital gains taxes of shareholders, as argued by Graham (2008). Finally, we analyse the impact of governance and taxes on the discrete dividend decision. We find higher probability of paying and increasing cash dividends and lower probability of decreasing dividends in countries with full and partial tax systems and where the tax differential ratio is high. Interestingly, the governance variable is not significant when we include the interactions of governance with the tax system and with the tax differential ratio. These interaction variables are positive and significant, suggesting that a combination of taxation and governance systems, rather than governance per se, is likely to explain why companies pay and change their dividends, although the impact of taxation and governance on the decision to buy back shares is not too strong, partly because repurchases were still not too popular during our sample period. Overall, our results suggest that, in strong investor protection countries, managers are more inclined to pursue shareholders' interest by paying out cash dividends when their tax disadvantage relative to capital gains is small. In contrast, in weak investor protection countries, managers can get away with setting up dividend policies that are independent of tax costs because investors' rights are not well protected and also investors are more concerned about governance than tax by aiming to extract the maximum amount of cash despite the tax consequences of such extraction. Our results provide an additional perspective to the agency explanation of dividends and show that the interrelation between agency costs and taxation explain dividend payouts across firms and countries. We contribute to previous cross-country studies in various ways. Unlike previous studies, we focus on the differences in tax systems following Graham's (2008) plea that it would be helpful if there were more studies that exploit the rich variation in tax codes around the world. We also provide more support for the tax effect on dividends and repurchases by showing that tax systems and the tax differential ratio affect both the amount and the propensity to pay and change dividends. 5 Finally, we find that governance and taxes jointly explain the cross-country behaviour of dividends and share repurchases. Contrary to the general findings in the literature that firms in strong investor protection countries pay out more dividends vis-à-vis firms in weak protection countries, we show that the validity of this observation depends on the extent of dividend tax disadvantage. While we expand previous studies by providing a relatively deeper analysis of the combined impact of investor protection and taxation on dividend payments, we recognise that our results may suffer from limitations inherent in cross-country studies as the accounting numbers may not be comparable, firms may be subject to tax and governance structures in other than their country of registration, they may face different effective corporate and personal tax rates, and they can have other internal and external corporate governance mechanisms to mitigate their agency conflicts, including specific ownership structure, insider ownership, and board structure, in addition to the magnitude of the country level investor protection. Although the unavailability of more disaggregated data limited our ability to test all these effects, we run a series of robustness tests to mitigate these limitations. We assess whether our results are driven by particular countries by excluding the heavily represented Japan, UK, and US where dividends are disappearing (Fama and French, 2001). We control for time-variation in the relation between dividends and firmspecific factors, as DeAngelo et al. (2008) suggest that the impact of taxes on dividend and repurchases can be gauged directly by observing the extent to which firms alter their payout decisions in response to tax law changes. We control for ownership structure as Mitton (2004) shows that the first-order determinant of payouts is the firm level shareholder protection together with the country level protection, and we use alternative definitions of governance including the recent Spamann (2010) corrected measure of anti-directors' rights. We find relatively similar qualitative results. The rest of the paper is structured as follows. In Section 1, we review the literature, present the tax framework, and set up our hypotheses. Section 2 describes the data and the methodology. In Section 3, we present an analysis of the empirical results. In Section 4, we report some robustness checks. Conclusions and discussions are set out in Section 5. 2. Review of the literature, institutional settings and hypotheses tested 2.1. Review of the literature Miller and Modigliani (1961) show that, in the absence of various frictions, firms cannot create value from their payout policy over and above the value they generate by their investment policy. In this paper we focus on two contrasting frictions: agency conflicts and taxes. When dividends are subject to agency conflicts, minority shareholders will require high dividends to prevent controlling investors from extracting private benefits from retained cash flow, and when dividends are taxed, firms are expected 5 Previous cross-country studies provide mixed evidence on the tax effect. For example, Pinkowitz et al. (2006) use dividend tax systems in their regressions; they find weak evidence for the tax effect. La Porta et al. (2000b) find inconsistent evidence on the role of tax on dividends, as the tax differential ratio is only significant when payout is measured as dividend to sales. Eije and Megginson (2008) find that the tax differential ratio is positive and significant in determining the probability of paying dividend, but negative and significant in determining its amount.

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to defer them until the present value of payout taxes are zero, or opt for share repurchases when capital gains taxes are lower than the taxes on dividends (e.g., DeAngelo et al., 2008). These arguments suggest that dividends will emanate from the trade-off between mitigation of agency conflicts and taxation. The empirical evidence on these two effects is relatively mixed as previous studies focus on single countries where the tax and governance systems do not change frequently, making it difficult to detect any of these effects directly. 6 Some studies attempt to overcome these problems by using natural experiments, such as the 2003 dividend tax cut in the US. However, while Chetty and Saez (2005) and Brown et al. (2007) report significant effects of this cut on the amount of dividends and the proportion of dividend payers, Blouin et al. (2011) find that all the dividend payments increases in the three months immediately after this reform was due solely to 17 firms who paid special dividends. Brav et al. (2008) show that dividend initiations surged temporarily after the adoption of this reform, but, inconsistent with the tax effect, they find that aggregate repurchases also increased. Their survey suggests that this reform had only a second-order influence on dividends. Other studies focus on cross-country differences in governance and tax systems to overcome some of these drawbacks. In terms of governance, La Porta et al. (2000b) find evidence consistent with the outcome hypothesis in which dividend payout is positively related to governance quality. Other subsequent studies also provide additional evidence on this effect. For example, Pinkowitz et al. (2006) show that dividends are valued more in weak investor protection countries. Brockman and Unlu (2009) find that country level creditor rights and dividend payout are positively related, consistent with the substitute model, as when creditor right is weak at country level, managers are more likely to restrict dividends in order to build a good reputation and, hence, reduce costs of capital. However, Shao et al. (forthcoming) find that the positive relationship between creditor rights and dividend payout is significant only when shareholder rights are strong. 7 However, cross-country studies either ignore tax effects (Denis and Osobov, 2008) or find that the tax differential ratio is positive and significant in determining the probability of paying dividend, but negative and significant in determining the amount of dividends (Eije and Megginson, 2008). Pinkowitz et al. (2006) split their countries into four groups based on dividend tax system and the corruption index. They find that the relationship between market value and cash holding is independent of the tax effect, and dividends contribute to market value only in countries with poor investor protection where dividends are tax disadvantaged. These results are not consistent with the tax hypothesis as dividends are likely to be more relevant to minority shareholders at the margin because dividend tax disadvantage subsidizes the consumption of private benefits.

2.2. Hypotheses tested We expect taxation to affect dividends in two ways. First, firms in the classic tax system countries will pay low or no dividends, and opt for share repurchases for tax efficiency. In contrast, in countries with more favourable dividend tax environments (partial and full imputation systems), firms will pay high dividends and will have a propensity to initiate and/or increase dividends. Second, firms with high (low) tax differential ratio are expected to pay high (low) dividends. These predictions follow Chetty and Saez (2010) and Morck and Yeung (2005) models in which dividend tax cut works as a tool to reduce the agency problem of free cash flow as managers cannot use dividend tax disadvantage as an excuse to retain excess cash when dividend tax is cut. However, these tax effects are more relevant in strong investor protection countries, where managers are expected to maximise the wealth of their shareholders by adopting payouts that maximise the after-tax returns of their shareholders. This discussion motivates our first hypothesis: Hypothesis 1. Firms in strong investor protection countries maximise their shareholders' after‐tax returns by substituting cash dividends for share repurchases. In weak investor protection counties, payouts are expected to be low and not a function of the tax system because managers are less likely to maximise the wealth of their shareholders through a tax efficient payout policy, and because investors are more likely to welcome whatever cash they can extract regardless of its tax disadvantage. This is in line with La Porta et al. (2000b) outcome model, in which controlling shareholders hoard cash to pursue their interests at the expense of minority investors. Thus, dividend taxation should not affect dividends payout in weak investor protection countries under the outcome model. Also, under the substitute model, managers choose to disgorge cash to their shareholders to build good reputation that facilitates future access to external financing. In this case, taxes do not impact payout decisions, as the main motive is reputation building and raising additional capital, rather than maximizing the after-tax return of shareholders. On the other hand, if managers decide to keep the cash rather than distribute it to their shareholders, they are not likely to use taxation as the main motive for their cash hoarding decision, as predicted by Chetty and Saez (2010) and Morck and Yeung (2005), because of their power over minority shareholders in making any decision. We, therefore, set the following second hypothesis:

6 For example, Desai and Jin (2011) show that taxable institutions hold shares in low payout firms, but Grinstein and Michaely (2005) do not find tax-based preferences by institutional investors. Taxation also does not explain the “disappearing dividend” phenomenon in the US (Fama and French, 2001; Julio and Ikenberry, 2005), or the dividend payment of UK private firms (Michaely and Roberts, 2012). Rau and Vermaelen (2002) find that tax changes affect share repurchases, unlike Dittmar (2000). See Allen and Michaely (2003) for a review on signalling, firm maturity, and behavioural motives. 7 Hu and Kumar (2004), Jo and Pan (2009), and Officer (2011) also use agency theory to explain dividend behavior. Other studies relate corporate governance to cash holding (e.g., Dittmar et al., 2003), and market liquidity (Chung et al., 2010).

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Hypothesis 2. Firms in weak investor protection countries do not pay attention to dividends taxation when setting their payout policy. 3. Data and methodology We first select all firms registered in 24 OECD countries from DataStream. We exclude Korea for lack of data, and Czech Republic, Slovak Republic, and Iceland for incomplete or unreliable data. We also exclude from our sample Hungary, Germany in 2000, Norway in 2006–2007, and Poland in 2002 because they apply either a split rate system or other dividend tax treatments, which are incomparable to other countries and may have unclear effect on dividends. We follow La Porta et al. (2000b) and exclude Greece because of the mandatory dividend rule forced on Greek firms. In addition, we eliminate firms with missing dividend or earning data and those with negative book equity, and financial and utility firms as their dividend policy may exhibit different motivations. Our final sample includes 9806 firms from 2000 to 2007, resulting in 44,194 firm/year observations. We follow Djankov et al. (2008) and use the anti‐self dealing index, Law, to capture corporate governance. The higher the index score, the higher the level of investor protection. Djankov et al. (2008) argue that the anti‐self dealing index measures investor protection better that pervious indices in La Porta et al. (1998). In our robustness checks, we simulate with alternative measures. We focus on two measures of taxation on dividends. The first is the classification of the countries in the sample into three tax systems based on the dividend tax credit, and the corporation tax rate: (i) classical system (Classical) where shareholders pay personal taxes on distributed earnings in addition to the corporate taxes paid on those earnings (double taxation), (ii) partial imputation system (Partial) where shareholders pay personal taxes on distributed earnings but receive tax credit for part of the corporate taxes paid on these earnings, and (iii) the full imputation system (Full) where shareholders pay personal taxes on distributed earnings but receive full tax credit for the corporate taxes paid on these earnings. We collect the relevant dividend tax data from the annual OECD tax database (www.oecd.org/ctp/taxdatabase), and each country's tax authorities' official websites, and we classify each country into the three systems accordingly. The second is the tax differential ratio, TD, defined as the after-tax dividend income over the after-tax capital gains. We calculate this variable for each country and sample period, assuming effective statutory tax rates on distributions of domestic source income to a resident individual shareholder, 8 taking account of corporate income tax, personal income tax and any type of imputation or relief to reduce the effects of double taxation. We start with the corporate and individual tax rates, which correspond to the top statutory rates. We then calculate the net individual tax rate applied to the paid dividends as the tax rate on dividends net of any relief or tax credit applicable to dividends. We extract the capital gain tax rates applied to long-term gain realized by individual resident on sold assets from Price Waterhouse: Corporate & Individual taxes: A worldwide Summary. To test our hypotheses, we first estimate the following model:

Payout i;t ¼ β0 þ β1 Fulli;t þ β2 Partiali;t þ β3 TDi;t þ β4 Lawi;t þ

8 X

βk CONTROLi;t þ εi;t

ð1Þ

k¼1

We use dividends (Div), repurchases (Rep) and total payout (Div + Rep), scaled by total assets ratio (TA), to measure payouts. 9 We also use sales, cash and net income as denominators of our payouts to provide robustness of our results. Fullit (Partialit) is a dummy variable equal to 1 if the firm is located in a country that adopts full (partial) imputation system, and zero otherwise. We expect these tax system variables and the tax differential ratio, TD, to be positive as payouts should be higher in partial and full imputation systems, relative to the classical tax system, and when the tax differential ratio is high. We also include a set of control variables, CONTROLSit, namely: (i) profitability, measured by ROA, the ratio of the profit after tax but before interest to total assets, (ii) size, measured by sales (ln(S)), (iii) growth, measured by M/B, the market value of the firm (total assets − book value of equity + market value of equity) divided by total assets, and %ΔTA, the percentage change in total assets, as in Fama and French (2001), (iv) financial risk, measured by leverage (D/E), the ratio of long-term debt over market value of equity, (v) business risk, measured by cash flow volatility (CFVol), the standard deviation of operating cash flow to total assets, as in Chay and Su (2009), and (vi) maturity, measured by the number of years the firm is in the database (AGE), following Grullon et al. (2002) and DeAngelo et al. (2006). We use two relevant macro economic variables: growth in GDP, gGDP, and Euro, a dummy for firms in the European Union (EU), as the tax harmonization practices in place may make the dividend taxation across the member states in our sample not independent. We measure our dependent variables using both raw and industry-adjusted data. We collect all the relevant share price and accounting data from DataStream. The data is measured in US dollars and winsorized at the top and bottom 1% to reduce the 8 We do not have data on the treatment of foreign income dividend as discussed in Graham et al. (2012). We assume that managers define their firm's dividend policy in relation to domestic investors, who set the price on the shares. We do not have data on share ownership to relax this assumption. In the robustness checks, we account for the aggregate foreign ownership in each country, which may reflect taxes for foreigners, as foreign ownership is expected to be more with high foreign tax advantages. 9 Share repurchases are popular in the U.S. (e.g., Allen and Michaely, 2003). In other countries, such as Germany, they are allowed only recently. However, during our sample period, we are not aware of institutional restrictions that would prevent companies in our sample to choose between cash dividends and share buybacks.

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possibility of data errors. We test for robustness by excluding zero dividend and negative earnings firms, and by using data in local currency, to avoid exchange rate impact. In line with La Porta et al. (2000b) and Eije and Megginson (2008), we use a country random effect specification to account for cross correlation between error terms among firms within the same country and accommodate the inclusion of time invariant variables, such as the EU dummy. We use industry-adjusted variables and include year dummies in our regressions. Our data also led us to use the Tobit model with country random effect, including industry and year dummies, in the following specification:  Payout i;t ¼

Payout i;t 0

if Payout i;t > 0 Otherwise

ð2Þ

Our second test relates to the impact of taxation and governance on the propensity to repurchase shares and/or to pay cash dividends, and on the decision to change dividend policy. We estimate the following probit model with country random effect to capture those impacts, including the tax reforms that make countries move from one tax system to another and changes in tax differential ratio: 8   X Pr di;t ¼ 1 ¼ β0 þ β1 Fulli;t þ β2 Partiali;t þ β3 TDi;t þ β4 Lawi;t þ βk CONTROLi;t þ εi;t

ð3Þ

k¼1

Where ditis an indicator function of whether firms in our sample pay, increase, or decrease their cash dividend. For share repurchases, ditindicates whether firm i in our sample bought back the shares in year t. We use the same control variables as in Eq. (1). We also include Dividend Premium, the difference in the logs of value weighted average market to book ratio of dividend payers and non-payers to account for the catering theory (Baker and Wurgler, 2004). We expect the propensity to pay and increase (decrease) dividends to be positively (negatively) related to TD, Partial, Full, and Law. In contrast, the propensity to repurchase shares should be negatively related to TD, Partial, Full, but positively related to Law to reflect strong investor protection, as managers will be inclined to mitigate any agency conflicts over the free cash flow by returning the cash to the shareholders rather than investing it in negative NPV projects. 4. Empirical results 4.1. Dividend payouts across governance and tax systems Table 1 reports summary statistics of the variables used in our analysis. The mean payout ratio is 23% but the median is 8%, implying that this ratio is skewed. Similar skewness is observed for dividend per share (DPS), earnings per share (EPS), and to a lesser extent return on assets (ROA), suggesting that some firms do not pay dividends and the profitability is relatively widely dispersed across our sample firms. Panel B reports the correlations between the tax and dividend variables. The tax differential ratio is negatively related to DPS and EPS, but positively related to dividends payout ratios. Finally, Law is positively related to all dividend ratios but negatively related to DPS and EPS, suggesting that firms in strong investor protection countries have higher payouts even though they are less profitable. We also find, but do not report for space considerations, that all dividend variables are positively related to profitability (EPS and ROA) and size (ln(S)), but negatively related to leverage (D/E), growth rates, as measured by market-to-book (M/B) and change in total assets (%ΔTA), and risk, as measured by cash flows volatility (CFVol), suggesting that growth and risky firms are likely to rely on internal financing, as corroborated by the negative correlation between these growth and risk measures and D/E. Table 2 presents the descriptive statistics of variables ranked by governance and tax systems. The results indicate that about 36% of the sample countries apply double taxation of dividends, 24% use full imputation, and 40% apply the partial imputation system. However, in terms of sample size, the respective proportions are 51%, 17%, and 32%, respectively, as the vast majority of our sample firms are from the US (26%) and Japan (11%) which apply the classical system. In the partial system, UK accounts for 16%, followed by Canada, Germany and France. In the full system, Australia and France are the most represented. The remaining countries are randomly distributed. Some countries, such as France, Finland, Portugal, Spain, and Norway, are in more than one category, because they switched their systems during the sample period. It is interesting to note that the average tax differential ratio TD is higher in some classical tax system countries than their counterparts in full and partial imputation countries. This is because even though dividends are doubled-taxed, some classical system countries have higher dividends tax advantage (higher TD) than other countries that use full or partial imputation. Overall, the average TD is significantly higher in the partial imputation system countries compared to the full imputation system and it is the lowest in the classical system. While these figures are averages, we find some changes in the corporate and individual tax rates during the sample period without any shift in the tax system. For example, the individual tax rate has changed from 60% in 2000 to 30% in 2001 in the Netherlands, from 31% in 2002 to 16% in 2003 in the US, and from 35% in 2005 to 40% in 2006 in Turkey. We also find, but do not report, that the average net individual income tax in classical system countries of 27% to be higher than that in partial imputation system of 24%, which in turn is higher than the 10% in full imputation system. Given the tax rates

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Table 1 Descriptive statistics of firm- and country-based variables. Panel A presents summary statistics of the main variables including number of observations (N), mean, median, standard deviation (SD), minimum (MIN), maximum (MAX). Panel B presents a correlation matrix of tax, law, and payout variables. The sample includes 44,194 firm/year observations from 24 OECD countries from 2000 to 2007. DPS is for dividend per share, EPS is earnings per share, Div/NI s the ratio of dividends over earnings. Div/S is the ratio of dividends to sales, Div/TA is the ratio of dividends to total assets, Div/CF is the ratio of dividends to cash flow from operation. Rep/NI is the ratio of repurchased shares during the year over earnings. Rep/TA is the ratio of repurchased shares during the year over total assets. Rep/TP is the ratio of repurchases over the sum of dividends and repurchases. ROA is profit after tax but before interest to total assets. Ln(S) is the natural logarithm of sales. D/E is long-term debt divided by the market value of equity. M/B is market value to book value of the firm. % Δ TA is the percentage change in total assets. Law is the score of anti‐self dealing index reported in Djankov et al. (2008). CFVol is the standard deviation of the log of operating cash flow. Repurchases is the ratio of repurchased shares during the year to total assets. Age is the number of years the firm is in the database. TD is the tax differential ratio, defined as the ratio of the after-tax dividend income to aftertax capital gains. DP is the dividend premium, defined as the difference in log value weighted average market to book ratio between dividend payers and non‐payers. gGDP is the growth in real GDP. Euro is a dummy variable that equals one if the country is an EU member and zero otherwise. The three dividend tax treatment types are: Classical where shareholders pay personal taxes on distributed earnings in addition to the corporate taxes paid on those earnings (double taxation), Partial where shareholders pay personal taxes on distributed earnings but receive tax credit for part of the corporate taxes paid on these earnings, and Full where shareholders pay personal taxes on distributed earnings but receive full tax credit for the corporate taxes paid on these earnings. All accounting variables are measured in US dollars for all firms and winsorized at the top and bottom 1%. All correlations coefficients in Panel B are significant at 1% level except the ones in bold. Panel A: summary statistics of firm- and country-based variables Variables

N

Mean

Median

SD

Min

Max

DPS EPS Div/NI Div/CF Div/TA Div/S Rep/TA Rep/NI Rep/TP ROA ln(S) D/E M/B %Δ TA CFVol Age DP TD Law gGDP Euro

44,194 44,194 44,194 42,627 44,194 44,194 42,953 42,953 42,953 44,194 44,194 44,194 44,194 39,238 42,361 44,194 44,194 44,194 44,194 44,194 44,194

0.29 0.92 0.23 0.12 0.01 0.01 0.00 0.06 0.18 0.01 6.08 0.38 1.79 0.18 0.06 13.76 0.06 0.96 0.59 2.52 0.38

0.04 0.34 0.08 0.04 0.00 0.00 0.00 0.00 0.00 0.03 6.19 0.18 1.29 0.05 0.04 12.00 0.11 0.97 0.64 2.51 0.00

0.69 2.11 0.41 0.20 0.02 0.03 0.01 0.21 0.35 0.13 2.02 0.6 0.97 1.89 0.05 5.93 0.31 0.19 0.21 1.33 0.48

0.00 − 5.47 − 1.42 − 0.66 0.00 0.00 0.00 − 0.30 0.00 − 1.03 0.01 0.00 0.56 − 0.99 0.00 1.00 − 0.85 0.40 0.17 − 5.70 0.00

14.53 14.97 3.44 1.49 0.16 0.33 0.14 1.80 1.00 0.27 11.71 5.08 9.39 173.9 2.22 30.00 1.33 1.51 0.95 9.36 1.00

Panel B: correlation matrix of tax, law, and payout variables

Classical Partial Full TD Law DPS EPS Div/NI Div/CF Div/S Div/TA Rep/TA Rep/NI Rep/TP

TD

Law

DPS

EPS

Div/NI

Div/CF

Div/S

Div/TA

Rep/TA

Rep/NI

Rep/TP

− 0.40 0.28 0.18 1

− 0.20 0.25 − 0.04 0.64 1

− 0.02 − 0.00 0.03 − 0.15 − 0.24 1

− 0.04 − 0.05 0.01 − 0.17 − 0.23 0.66 1

− 0.11 0.05 0.08 0.09 0.04 0.31 0.10 1

− 0.02 0.01 0.01 0.01 0.01 0.03 0.00 0.03 1

− 0.18 0.08 0.14 0.13 0.07 0.32 0.12 0.48 0.04 1

− 0.19 0.10 0.14 0.17 0.09 0.38 0.16 0.55 0.05 0.74 1

0.16 − 0.11 − 0.09 − 0.02 0.04 0.05 0.13 0.00 − 0.00 0.05 0.09 1

0.18 − 0.12 − 0.09 − 0.05 0.02 0.03 0.09 0.05 − 0.00 0.02 0.03 0.79 1

0.07 − 0.06 − 0.02 − 0.09 − 0.06 − 0.11 − 0.05 − 0.17 − 0.01 − 0.15 − 0.18 0.43 0.45 1

variation within and across countries, we expect the combination of the tax differential ratio, together with the tax system, to provide a richer environment and a unique opportunity to test whether the tax environment affects dividend policy. We find a monotonic increase (decrease) in dividend payout (repurchases) as we move from classical to full system in strong protection countries (Table 2, Panel A). The average tax differential ratio TD is highest in the partial imputation system (1.14) and lowest in classical system (0.93). Panel A also shows that EPS and DPS are higher in the classical tax system, and Panel B shows an increase in dividend payout in weak protection countries, as we move from the classical to partial and full systems, but the magnitude of the increase although significant, is rather small. In addition, the average repurchase ratio is not consistent with the dividend tax disadvantages. Unlike Panel A, firms in the classical system country have lower DPS and EPS in weak protection countries, and the average TD increases as we move from the classical to full systems. Overall, our results show that the tax impact on dividends and repurchases is stronger in strong, compared to weak protection countries.

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Table 2 Tests for mean differences of main variables in a two-way split across tax systems and governance quality. This table reports the differences in dividend levels, payouts, tax differential ratio (TD), and investor protection levels (Law), across subsamples based on tax systems, and investor protection levels. The overall sample includes 44,194 firm/year observations from 24 OECD countries from 2000 to 2007. A country is classified as strong (weak) if its anti-self dealing index score, as reported in Djankov et al. (2008), is above (below) than the mean anti-self dealing index score of the broader sample. The remaining variables are defined in Table 1. Country

No. firms

No. obs.

Panel A: strong protection countries a) Classical tax system Ireland 59 291 USA 2612 12,093 2671 12,384 b) Partial imputation tax system Canada 769 3,021 UK 1573 6063 2342 9084 c) Full imputation tax system Australia 880 3478 New Zealand 66 310 946 3788 Panel B: weak protection countries a) Classical tax system Austria 75 291 Belgium 76 357 Denmark 99 467 Netherlands 168 824 Japan 1,051 6,291 Poland 113 377 Portugal 46 94 Spain 118 71 Sweden 179 837 Switzerland 143 512 2068 10,121 b) Partial imputation tax system Finland 113 232 France 623 1027 Germany 467 1906 Italy 218 578 Luxembourg 18 83 Norway 94 62 Portugal 46 149 Spain 118 530 Turkey 154 685 1851 5252 c) Full imputation tax system Finland 113 371 France 623 1,942 Italy 218 460 Mexico 97 523 Norway 94 269 1145 3565 Panel C: overall sample All strong 5959 All weak 5064 All classical 4739 All partial 4193 All full 2091 All sample 11,032 ⁎ a b c

25,256 18,938 22,505 14,336 7353 44,194

TD

Law

DPS

EPS

Div/NI

Div/TA %

Rep/NI

Rep/TA %

Rep/TP

0.72 0.94 0.93

0.79 0.65 0.65

0.10 0.21 0.21

0.42 0.98 0.97

0.19 0.12 0.12

1.30 0.67 0.68

0.03 0.13 0.13

0.16 0.90 0.88

0.10 0.23 0.23

0.93 1.25 1.14

0.64 0.95 0.85

0.21 0.12 0.15

0.67 0.20 0.36

0.17 0.31 0.26

1.06 1.84 1.58

0.04 0.03 0.03

0.26 0.22 0.23

0.15 0.12 0.13

1.05 1.49 1.09

0.76 0.95 0.78

0.08 0.11 0.08

0.11 0.14 0.11

0.35 0.50 0.36

2.31 3.25 2.39

0.02 0.02 0.02

0.15 0.12 0.15

0.12 0.12 0.12

0.75 0.85 0.57 0.67 0.86 1.00 0.84 0.96 1.00 0.59 0.83

0.21 0.54 0.46 0.20 0.50 0.29 0.44 0.37 0.33 0.27 0.43

0.99 1.03 1.04 0.74 0.13 0.32 0.17 0.43 0.43 1.28 0.37

2.85 2.61 2.91 1.69 0.46 1.09 0.42 1.46 0.91 3.97 1.06

0.26 0.24 0.24 0.29 0.25 0.18 0.26 0.23 0.33 0.24 0.26

1.10 1.38 1.31 1.65 0.65 1.29 1.14 1.41 2.24 1.25 1.00

0.04 0.06 0.69 0.05 0.07 0.02 0.06 0.05 0.06 0.06 0.09

1.72 3.98 0.69 0.37 0.22 0.11 0.27 0.22 0.43 0.44 0.45

0.14 0.19 0.24 0.16 0.19 0.18 0.24 0.20 0.12 0.20 0.18

1.15 0.91 0.76 0.94 0.80 1.24 0.89 0.91 0.77 0.85

0.46 0.38 0.28 0.42 0.28 0.42 0.44 0.37 0.43 0.36

0.71 0.97 0.57 0.24 0.40 0.28 0.11 0.42 0.18 0.53

1.24 2.84 1.55 0.57 1.24 0.70 0.27 1.33 0.43 1.46

0.44 0.24 0.22 0.26 0.14 0.23 0.25 0.27 0.18 0.24

3.82 1.30 1.00 1.13 1.22 1.10 0.94 1.48 1.50 1.31

0.00 0.00 0.00 0.00 0.09 0.09 0.05 0.03 0.00 0.01

0.01 0.01 0.02 0.01 0.54 0.50 0.20 0.16 0.01 0.05

0.12 0.14 0.22 0.19 0.22 0.26 0.19 0.14 0.21 0.19

1.41 0.85 0.96 1.00 1.39 0.99

0.46 0.38 0.42 0.17 0.42 0.37

0.72 0.89 0.14 0.04 0.42 0.62

1.17 2.90 0.21 0.20 0.93 1.83

0.46 0.21 0.27 0.15 0.30 0.24

2.68 1.11 1.02 1.09 1.52 1.29

0.01 0.01 0.01 0.07 0.03 0.02

0.04 0.02 0.02 0.47 0.14 0.10

0.13 0.20 0.25 0.28 0.12 0.20

1.03 a,b,c 0.87 a,b,c 0.89 1.04 1.04 0.96 ⁎,a,b

0.74 a,b,c 0.40 a,b,c 0.53 0.69 0.58 0.59 ⁎,a,b,c

0.17 a,b,c 0.46 a,b,c 0.28 0.29 0.34 0.29 ⁎,b,c

0.62 a,b,c 1.32 a,b,c 1.01 0.76 0.94 0.92 ⁎,a,b,c

0.21 a,b,c 0.25 a,b 0.18 0.26 0.30 0.23 ⁎,a,b,c

1.26 a,b,c 1.14 a,b 0.83 1.49 1.86 1.21 ⁎,a,b,c

0.08 a,b,c 0.06 a,b,c 0.10 0.02 0.02 0.06 ⁎,a,b,c

0.54 a,b,c 0.27 a,b,c 0.61 0.17 0.13 0.38 ⁎,a,b,c

0.18 a,b 0.19 b,c 0.21 0.15 0.16 0.18 ⁎,a,b,c

Denote significantly different from zero at the 1% level between strong and weak protection, using two-tailed t-tests. Denote significantly different from zero at less than 5% level between Classical vs. Partial, using two-tailed t-tests. Denote significantly different from zero at less than 5% level between Classical vs. Full, using two-tailed t-tests. Denote significantly different from zero at less than 5% level between Partial vs. Full, using two-tailed t-tests.

Table 3 presents further evidence on the impact of taxation and governance on payout ratios. We classify our sample into tax systems (classical, partial and full), tax differential ratios (where high (low) TD indicates above (below) average TD), and shareholder protection (where strong (weak) indicates above (below) average anti-self dealing index). We test for differences in means using the t-test. The average total payout (Panel A) and also the ratios of cash dividends (Panel B) and repurchases (Panel C) are significantly higher in strong protection compared to weak protection countries. These results are consistent with previous

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evidence (e.g., La Porta et al., 2000b) and suggest that in strong protection countries shareholders are likely to make managers disgorge cash that, otherwise, might be used to undertake negative NPV projects. However, the distribution of these ratios across tax and governance systems is not homogenous. Interestingly, in the classical system the reverse is observed as the average cash dividend payout in weak protection countries is significantly higher than that in the strong protection countries. For the remaining tax systems, the results are consistent with the outcome hypothesis as firms in strong protection countries pay higher dividends than those in weak protection countries. We also find, but do not report, similar results when we define payout as dividends over earnings, as firms in the classical tax system and strong protection countries pay only 12% of their earnings as dividends, compared to 26% for those in weak governance countries, but the respective average payout ratios for strong and weak protection countries are 36% and 24% under full tax system, and 27% and 24% under partial tax system. The differences between these ratios are all significant. Table 3, Panel A and B also shows that total payout and cash dividend payout in strong protection countries are affected by the tax differential ratio, TD. In particular, in Panel B dividends in high TD countries are about twice those in low TD countries. We obtain similar results for the sample of weak protection countries and when we use dividend over earnings (0.25 in high TD vs. 0.13 in low TD). The last three columns indicate that when TD is high, the average payout is significantly higher than when TD is low. The average payout is significantly higher in the full imputation compared to the classical tax system in both low and high TD countries, but especially in high TD countries as the distribution of payout is monotonic across tax systems. When we divide dividends by earnings, we find similar results with a mean payout ratio of 26% in high compared to 20% in low TD countries (p = 0.00), and the difference is more pronounced when we account for the tax system. Panel C reports the distribution of repurchases over total assets. The results show that, in strong protection countries, repurchases are the highest in the classical and lowest in the full imputation tax systems, and they are also statistically higher in low TD countries. In the weak protection countries, repurchases are not evenly distributed across tax systems and they are higher in high TD groups, in contrast to our predictions. In the last columns, the distribution of repurchases across TD groups is also not as expected. 4.2. Impact of taxation on the payout ratios In Table 4, we run a set of regressions to explain the levels of payouts. The dependent variable is total payout in models (1) to (3), cash dividends in (4) to (6) and share repurchases in (7) to (9), all scaled by total assets. For each dependent variable, we present regression results based on random effect econometric specification, using industry-adjusted data 10 and including year dummies, for the whole sample and for a subsample of nonzero dependent variable. We also run Tobit model with country random effect, as specified in Eq. (1) with year and industry dummies. Robust standard errors in all regressions are clustered by country, and in Tobit model we use bootstrapping for clustered standard errors. Consistent with previous evidence (e.g., La Porta et al., 2000b), we find that the shareholder protection variable, Law, is positive and significant in all our specifications, suggesting that in strong protection countries, firms are likely to pay high cash dividends and also to repurchase shares. 11 However, this variable does not tell us how firms choose between dividends and share repurchases, and whether managers destroy shareholder value by paying dividends. Thus, investor protection variable does not appear to be a clear determinant of the firm's payout decisions. To overcome this drawback we assess whether firms pay cash dividends (repurchase shares) when the tax cost on dividends is low (high), and whether taxes and shareholder protection are joint determinants of firms' dividend payment across countries. The tax coefficients in Table 4 provide a strong indication that companies in the full and partial imputation system countries pay significantly higher dividends than those in the classical system. In Model (4) and (6), the results also indicate that the impact of the full system on cash dividends is higher than that in the partial, as the coefficients of Full are economically higher. However, when we use dividend payers only (Model (5)), the coefficients of Full and Partial are relatively the same. The coefficient of the tax differential ratio, TD, is not significant in Model (5), but it is, as expected, positive and significant in the remaining models. In Model (7) to (9), the relationship between repurchases and taxation is even stronger. As expected, the results indicate that companies that operate in the full and partial tax system, and whose shareholders are taxed at a lower rate on dividends relative to capital gains, repurchase significantly less. These results are independent of the specification we use. We note, however, that the coefficients of Full and Partial are economically relatively similar, suggesting that there is not much difference in the amount of repurchases between full and partial systems. The results also indicate that cash dividends and share repurchases are substitutes as the coefficients of repurchases (cash dividends) are negative in the dividend (repurchases) regressions, in line with some previous studies (Grullon and Michaely, 2002; Jagannathan et al., 2000). Our results imply that firms substitute dividends for repurchases to minimise the tax liability of their shareholders, as our regressions control for all other likely fundamental factors. 12 10

We also experiment with unadjusted data and the results still hold. With almost similar set of controlling variables and similar sample period, Eije and Megginson (2008) report no significant effect of legal environment on dividend policy of EU member countries. We also find strong impact when we use other investor protection variables, such legal origin or anti director rights, reported in robustness checks section. 12 Some studies argue that dividends and repurchases may not be substitutes. For example, Vermaelen (1981) states the conditions whereby repurchases are taxed as dividends, and, thus, may not work as perfect substitutes. Dittmar (2000) finds that repurchasing firms do not necessarily have lower dividend payout ratios. Brennan and Thakor (1990) argue that repurchases can carry high information asymmetry cost that may washout any tax advantage from them, especially when firms are perceived to be taking advantage of shareholders. Allen et al. (2000) develop a model in which firms pay dividends to attract untaxed institutional clientele, and dividends and repurchase are not substitute as firms will use dividends rather than repurchases for signalling and agency reduction motives. 11

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Table 3 Tests for mean differences of payouts in a three-way split across tax systems, tax differential ratio, and governance quality. The table reports the means of total payout (dividend plus repurchases) (Panel A), dividend (Panel B), and repurchases (Panel C) over total assets, across investor protection, tax differential, and tax systems and the tests for the mean differences across subsamples. The tax systems are defined in Table 1. A country is classified as high (low) TD in certain period if its TD is larger (smaller) than the mean TD of the broader sample. A country is classified as strong (weak) if its anti-self dealing index score, as reported in Djankov et al. (2008), is above (below) than the mean anti-self dealing index score of the broader sample. The overall sample includes 44,194 firm/year observations from 24 OECD member countries between 2000 and 2007. p − χ2 is p-value of Chi-square statistics to test for homogeneity across the groups. System

All

Investor protection

Tax differential ratio (TD)

Strong

Weak

(Strong–Weak)

High

Low

(High–Low)

Panel A: mean (Div + Rep)/TA (%) Classical 1.545 Partial 1.680 Full 2.004 0.000 p − χ2 High TD Low TD t High–Low All 1.666 abc

1.717 1.852 2.563 0.000 2.070 1.541 0.529⁎⁎⁎

1.339 1.386 1.414 0.000 1.593 1.257 0.336⁎⁎⁎ 1.366

0.377⁎⁎⁎ 0.466⁎⁎⁎ 1.149⁎⁎⁎

1.610 2.076 2.416 0.000

1.489 1.242 1.112 0.000

0.120⁎⁎⁎ 0.833⁎⁎⁎ 1.299⁎⁎⁎

0.528⁎⁎⁎

1.941

1.369abc

0.572⁎⁎⁎

Panel B: mean Div/TA (%) Classical 0.825 Partial 1.490 Full 1.856 0.000 p − χ2 High TD Low TD High–Low All 1.212

0.682 1.581 2.389 0.000 1.530 0.725 0.805⁎⁎⁎

1.000 1.333 1.290 0.000 1.301 1.073 0.228⁎⁎⁎ 1.147 ab

− 0.318⁎⁎⁎ 0.248⁎⁎⁎ 1.099⁎⁎⁎

0.873 1.797 2.211 0.000

0.785 1.149 1.088 0.000

0.088⁎⁎⁎ 0.648⁎⁎⁎ 1.123⁎⁎⁎

0.115⁎⁎⁎

1.469abc

0.935

0.344 0.054 0.124 0.000 0.296 0.188 0.108⁎⁎⁎ 0.222a,b,c

0.703⁎⁎⁎ 0.228⁎⁎⁎ 0.064⁎⁎⁎

0.743 0.291 0.216 0.000

0.713 0.096 0.030 0.000

0.030 0.195⁎⁎⁎ 0.186⁎⁎⁎

0.478a,b,c

0.439a,b,c

0.039

abc

Panel C: mean Rep/TA (%) Classical 0.098 Partial 0.024 Full 0.019 0.000 p − χ2 High TD Low TD t High–Low All 0.459a,b,c

1.894

1.262

abc

ab

1.047 0.282 0.188 0.000 0.545 0.827 − 0.282⁎⁎⁎ 0.639a,b,c

0.477⁎⁎⁎ 0.284⁎⁎⁎

0.229⁎⁎⁎ − 0.348⁎⁎⁎

0.249⁎⁎⁎ 0.636⁎⁎⁎ 0.417⁎⁎⁎

abc

ab

0.534⁎⁎⁎

⁎⁎⁎ Denote significantly different from zero at the 1% level between strong and weak protection, using two-tailed t-tests. a Denote significantly different from zero at 1% level between Classical vs. Partial, using two-tailed t-tests. b Denote significantly different from zero at 1% level between Classical vs. Full, using two-tailed t-tests. c Denote significantly different from zero at 1% level between Partial vs. Full, using two-tailed t-tests.

The coefficients of the control variables are relatively as expected. Profitability (ROA) is positive, but debt to equity ratio (D/E) is negative, suggesting that profitable firms have higher payout, but that high leverage reduces dividends because of debt covenants or low free cash flow problems. Dividends are negatively related to the percentage change in total assets (%ΔTA) and to cash flow uncertainty (CFVol), suggesting that risky firms pay low dividends, in line with Chay and Su (2009). 13 AGE is positive and significant, in line with the life cycle theory (DeAngelo et al., 2006) and firm's maturity effect (Grullon et al., 2002). Unlike Eije and Megginson (2008), the dummy variable (Euro) is positive in our dividend but negative in repurchases regressions. Finally, M/B is positive and significant and, in Model (5), size (ln(S)) is negative and significant, in contrast to previous evidence (e.g., Fama and French, 2001) where large and mature firms have higher payouts. However, the negative size effect applies only when nondividend paying firms, which are usually the smallest, are excluded from the sample. Overall, our results contribute to the controversial debate and mixed results in the literature on the impact of taxation on dividends (see, e.g., Graham (2008) for a review). Consistent with some previous studies (e.g., Akhtar, 2008; Pattenden and Twite, 2008), we find that tax systems shape payout in the OECD countries. Moreover, unlike the results of previous studies (e.g., Eije and Megginson, 2008; La Porta et al., 2000b), the tax differential ratio, TD, is positive (negative) and significant in all our dividend (repurchases) specifications, suggesting that shareholder tax preferences affect dividends. Our results contribute to previous evidence by showing that both the tax system and shareholders' personal taxes affect firms' payout ratios.

13

We find similar results when we use the standard deviation of ROA.

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Table 4 Dividend and repurchases payouts regressions the overall sample. The table reports coefficients estimates from regressions of total payout (Div + Rep), dividends (Div), and share repurchases (Rep), scaled by total assets, on dividend tax, investor protection, and several control variables. The data includes 44,194 observations from 23 OECD countries in 2000–2007. Regressions (1), (4) and (7) use industry-adjusted data and country random effect; Regressions (2), (5) and (8) include dividend payers and repurchasing firms, dividend payers only, and repurchasing firms only, respectively, using industry-adjusted data and country random Effect; Regressions (3), (6) and (9) are based on Tobit model with country random effect. We report Pseudo R2 for regressions (3), (6) and (9). The remaining variables are as defined in Table 1. Clustered standard errors by country, estimated in Eqs. (3), (6) and (9) using the bootstrapping method with 500 iterations, are in parentheses. Dependent variables

(Div + Rep)/TA

Div/TA

Rep/TA

Model

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

Intercept

− 0.004⁎⁎⁎ (0.000) 0.005⁎⁎⁎

0.004 (0.004) 0.005⁎⁎⁎

− 0.043⁎⁎⁎ (0.002) 0.012⁎⁎⁎

− 0.019⁎⁎⁎ (0.001) 0.011⁎⁎⁎

− 0.007⁎⁎⁎ (0.002) 0.004⁎⁎⁎

− 0.045⁎⁎⁎ (0.003) 0.016⁎⁎⁎

− 0.012⁎⁎⁎ (0.003) − 0.007⁎⁎⁎

− 0.032⁎⁎⁎ (0.004) − 0.007⁎⁎⁎

(0.002) 0.002 (0.002) − 0.004⁎⁎⁎ (0.001) 0.013⁎⁎

(0.002) 0.003⁎ (0.002) − 0.008⁎⁎⁎ (0.001) 0.015⁎⁎

(0.001) 0.001⁎⁎ (0.001) 0.001 (0.001) 0.019⁎⁎⁎

(0.000) 0.004⁎⁎⁎ (0.000) 0.003⁎⁎⁎

(0.001) 0.006⁎⁎⁎ (0.001) 0.004⁎⁎⁎

(0.001) − 0.008⁎⁎⁎ (0.001) − 0.005⁎⁎⁎

(0.001) − 0.008⁎⁎⁎ (0.001) − 0.003⁎⁎

(0.001) 0.009⁎⁎⁎

(0.001) 0.005⁎⁎⁎ (0.001) − 0.001 (0.001) 0.012⁎⁎⁎

− 0.001 (0.001) − 0.003⁎⁎⁎ (0.000) − 0.004⁎⁎⁎ (0.000) − 0.002⁎⁎⁎

(0.001) 0.012⁎⁎⁎

(0.001) 0.008⁎⁎⁎

(0.001) 0.025⁎⁎⁎

(0.002) 0.004⁎⁎⁎

(0.006)

(0.006)

(0.001)

(0.000) − 0.006⁎⁎⁎ (0.000)

(0.004) − 0.010⁎⁎ (0.004)

(0.002) − 0.019⁎ (0.011)

(0.001)

(0.001)

(0.002)

− 0.001⁎⁎⁎ (0.002) 0.012⁎⁎⁎

− 0.002⁎⁎⁎ (0.000) 0.011⁎⁎⁎

− 0.001⁎⁎ (0.000) 0.039⁎⁎⁎

(0.000) 0.001⁎⁎⁎ (0.000) − 0.001⁎⁎⁎ (0.000) − 0.000⁎⁎⁎

(0.002) 0.002⁎⁎⁎ (0.000) − 0.002⁎⁎⁎ (0.000) − 0.006⁎⁎⁎

(0.003) 0.003⁎⁎⁎ (0.000) − 0.001⁎⁎⁎ (0.000) − 0.016⁎⁎⁎

(0.000) 0.002⁎⁎⁎ (0.000) 0.002 (0.001) − 0.000⁎⁎⁎ (0.000) − 0.000 (0.000) − 0.011⁎⁎⁎

(0.001) 0.009⁎⁎⁎ (0.000) 0.011⁎⁎⁎ (0.004) − 0.001⁎⁎⁎ (0.000) 0.001⁎⁎⁎

(0.001) 0.000 (0.000) − 0.002 (0.005) 0.000 (0.000) − 0.000 (0.000) − 0.003⁎⁎⁎ (0.001) 2756.5⁎⁎⁎ (0.12) 38,246

Full Partial TD Law Rep Div

0.050⁎⁎⁎ (0.001) 0.002⁎⁎⁎

0.088⁎⁎⁎ (0.003) 0.001⁎⁎⁎

0.113⁎⁎⁎ (0.004) 0.004⁎⁎⁎

0.039⁎⁎⁎ (0.001) 0.001⁎⁎⁎

0.102⁎⁎⁎ (0.006) − 0.001⁎⁎⁎

0.179⁎⁎⁎ (0.007) 0.002⁎⁎⁎

%ΔTA

(0.000) − 0.005⁎⁎⁎ (0.000) − 0.000⁎⁎⁎

(0.000) − 0.005⁎⁎⁎ (0.000) − 0.003⁎⁎⁎

(0.000) − 0.006⁎⁎⁎ (0.000) − 0.005⁎⁎⁎

(0.000) − 0.004⁎⁎⁎ (0.000) − 0.001⁎⁎⁎

(0.000) − 0.003⁎⁎⁎ (0.000) − 0.003⁎⁎

(0.000) − 0.006⁎⁎⁎ (0.000) − 0.002⁎⁎⁎

M/B

(0.000) 0.005⁎⁎⁎ (0.000) − 0.015⁎⁎⁎ (0.003) 0.000⁎⁎⁎ (0.000) − 0.000⁎

(0.001) 0.010⁎⁎⁎ (0.000) − 0.015⁎⁎⁎ (0.003) 0.000⁎⁎⁎ (0.000) − 0.001⁎⁎⁎

(0.002) 0.005⁎⁎⁎ (0.000) − 0.032⁎⁎⁎ (0.005) 0.000⁎⁎⁎ (0.000) 0.001⁎⁎⁎

(0.000) 0.004⁎⁎⁎ (0.000) − 0.011⁎⁎⁎ (0.002) 0.001⁎⁎⁎ (0.001) 0.001⁎⁎⁎

(0.001) 0.002⁎⁎⁎ (0.000) − 0.075⁎⁎⁎ (0.008) 0.001⁎⁎⁎ (0.000) 0.001⁎⁎⁎

(0.000) 0.001 (0.002) 6499.3⁎⁎⁎ 0.19 38,246

(0.000) − 0.001 (0.002) 5524.4⁎⁎⁎ 0.27 27,296

(0.000) 0.005⁎⁎⁎ (0.000) 6492.9⁎⁎⁎ (0.13) 38,246

(0.000) 0.004⁎⁎⁎ (0.000) 9345.9⁎⁎⁎ 0.46 38,246

(0.001) 0.007⁎⁎⁎ (0.000) − 0.011⁎⁎ (0.005) 0.001⁎⁎⁎ (0.000) − 0.000 (0.000) 0.005⁎⁎⁎

ROA ln(S) D/E

CFVol Age gGDP Euro Wald λ2 Adj (Pseudo)R2 N

(0.000) 3768.2⁎⁎⁎ 0.50 22,113

(0.000) 0.006⁎⁎⁎ (0.001) 10238⁎⁎⁎ (0.24) 38,246

(0.000) 3538.2⁎⁎⁎ 0.27 38,246

(0.000) − 0.000 (0.000) 3472.1⁎⁎⁎ 0.33 14,755

⁎⁎⁎ ⁎⁎ ⁎

Denote significantly different from zero at the 1% level between strong and weak protection, using two-tailed t-tests. Denote significantly different from zero at the 5% level between strong and weak protection, using two-tailed t-tests. Denote significantly different from zero at the 10% level between strong and weak protection, using two-tailed t-tests.

4.3. The interaction between taxation and investor protection In this section we examine whether taxation affects payouts in a similar way across strong and weak protection countries. We divide our sample firms into two subsamples based on the level of investor protection. A strong protection subsample includes firms in countries with above average anti‐self dealing index while weak protection subsample includes the remaining firms. The results, reported in Table 5 are based on industry-adjusted data with country random effect (Model (1)), and Tobit model with country random effect (Model (2)) for cash dividend, and similar specifications in models (3) and (4) for repurchases. The first column shows that, in line with previous results, in strong shareholder protection countries, firms that operate in full and partial imputation systems pay higher dividends than those in the classical system. The coefficient of Full is higher than that of Partial, suggesting that, economically, firms in the full system pay the highest amount of dividends, followed by those in the partial, and in the classical the payout is lowest. The tax differential ratio TD is also positive and significant, suggesting that the tax system at both firm and shareholder levels affect dividend payments. However, companies do not substitute cash dividends for repurchases as Rep/TA is negative but not significant. We obtain similar results in column (2) with the Tobit specification, except that TD is positive but not significant. Similarly, in the repurchases regressions, reported in columns (3) and (4), TD, is not significant, but the coefficients of Full and Partial are negative and significant, suggesting that firms that operate in the full and partial system are less likely to repurchase their stock, compared to those in the classical system. Overall, although TD may not have a strong effect on dividends and repurchases in the strong shareholder protection countries, firms that operate in the classical tax system are less likely to pay cash dividends, but they recur to share repurchases to maximise their shareholders'

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Table 5 Dividend and repurchases payouts regressions for subsamples based on governance quality. The table reports coefficients estimates from regressions of dividends (Div), and share repurchases (Rep), scaled by total assets, within strong and weak governance systems, on dividend tax, and several control variables. The data includes 44,194 observations from 23 OECD countries in 2000–2007. Regressions (1) and (3) use industry-adjusted data and country random effect. Regressions (2) and (4) are based on Tobit model with county random effect. The remaining variables are as in Table 1. Clustered standard errors by country, estimated in Eqs. (2) and (4) using the bootstrapping method with 500 iterations, are in parentheses. Div/TA Model

(1)

Law system

Strong

Rep/TA (2) Weak

Panel A. Impact of taxation across governance systems Intercept − 0.010⁎⁎⁎ 0.005⁎⁎ (0.001) (0.003) Full 0.021⁎⁎⁎ 0.000 (0.001) (0.001) ⁎⁎⁎ Partial 0.006 0.001 (0.000) (0.001) TD 0.004⁎⁎⁎ − 0.002⁎⁎⁎

(3)

(4)

Strong

Weak

Strong

Weak

Strong

Weak

− 0.023⁎⁎⁎ (0.003) − 0.005⁎⁎⁎ (0.001) − 0.001 (0.001) 0.017⁎⁎⁎

0.005⁎⁎⁎ (0.001) − 0.004⁎⁎⁎ (0.000) − 0.004⁎⁎⁎ (0.000) 0.001 (0.001)

− 0.002⁎⁎⁎ (0.001) − 0.001⁎⁎⁎ (0.000) − 0.003⁎⁎⁎ (0.000) − 0.003⁎⁎⁎

− 0.055⁎⁎⁎ (0.006) − 0.012⁎⁎⁎ (0.001) − 0.008⁎⁎⁎ (0.001) 0.008⁎⁎

− 0.008⁎⁎ (0.003) − 0.003⁎⁎⁎ (0.001) − 0.006⁎⁎⁎ (0.001) − 0.005⁎⁎⁎

(0.001)

(0.003)

(0.001)

0.001⁎ (0.000) 0.007⁎⁎⁎ (0.001) 0.001⁎⁎⁎

− 0.003⁎⁎⁎ (0.001) 0.055⁎⁎⁎ (0.004) 0.004⁎⁎⁎

0.001⁎⁎⁎ (0.000) 0.009⁎⁎⁎ (0.002) 0.001⁎⁎⁎

(0.001) − 0.005 (0.003)

(0.001) 0.020⁎⁎⁎ (0.003)

− 0.055⁎⁎⁎ (0.003) 0.040⁎⁎⁎ (0.001) 0.013⁎⁎⁎ (0.001) 0.002 (0.002) 0.007 (0.010)

0.028⁎⁎⁎ (0.001) 0.002⁎⁎⁎

0.072⁎⁎⁎ (0.003) 0.001⁎⁎

0.152⁎⁎⁎ (0.007) 0.005⁎⁎⁎

0.232⁎⁎⁎ (0.008) 0.001⁎⁎⁎

− 0.001⁎⁎⁎ (0.000) 0.120⁎⁎⁎ (0.001) 0.002⁎⁎⁎

(0.000) − 0.004⁎⁎⁎ (0.000) − 0.001⁎⁎⁎ (0.000) 0.004⁎⁎⁎

(0.000) − 0.003⁎⁎⁎ (0.000) − 0.001⁎⁎⁎ (0.000) 0.005⁎⁎⁎

(0.000) − 0.006⁎⁎⁎ (0.000) − 0.002⁎⁎ (0.001) 0.002⁎⁎⁎

(0.000) − 0.005⁎⁎⁎ (0.000) − 0.003⁎⁎⁎ (0.001) 0.003⁎⁎⁎

(0.000) − 0.002⁎⁎⁎ (0.000) − 0.001⁎⁎⁎ (0.000) 0.002⁎⁎⁎

(0.000) − 0.007⁎⁎⁎ (0.000) − 0.001⁎⁎⁎ (0.000) 0.001⁎⁎⁎

(0.000) − 0.001⁎ (0.001) − 0.024⁎⁎⁎ (0.003) 0.001⁎

(0.000) − 0.001⁎⁎⁎ (0.000) − 0.008⁎⁎⁎ (0.001) − 0.001⁎

Euro

(0.000) − 0.014⁎⁎⁎ (0.002) 0.001⁎⁎⁎ (0.000) − 0.001⁎⁎⁎ (0.000) 0.006⁎⁎⁎

(0.000) − 0.082⁎⁎⁎ (0.008) 0.001⁎⁎⁎ (0.000) − 0.001⁎⁎ (0.000) 0.016⁎⁎⁎

(0.000) − 0.063⁎⁎⁎ (0.006) 0.000⁎⁎⁎ (0.000) 0.001⁎⁎⁎ (0.000) 0.005⁎⁎⁎

(0.000) − 0.001 (0.002) 0.001⁎⁎⁎ (0.000) − 0.001⁎⁎ (0.000) − 0.002⁎⁎⁎

(0.000) − 0.001 (0.001) 0.000 (0.002) 0.001⁎⁎⁎ (0.000) − 0.001⁎

(0.001) − 0.002 (0.008) 0.001⁎⁎ (0.000) − 0.000 (0.000) − 0.009⁎⁎⁎

(0.001) − 0.002 (0.003) 0.000 (0.000) 0.000⁎⁎⁎ (0.000) − 0.003⁎⁎

(0.001) (0.000) 5709.1⁎⁎⁎ 0.99 21,651

(0.001)

(0.001) 4635.8⁎⁎⁎ (0.18) 16,595

(0.000) (0.000) 713.61⁎⁎⁎ 0.35 16,595

(0.001)

7861.7⁎⁎⁎ 0.43 21,651

(0.000) (0.000) 1807.2⁎⁎⁎ 0.75 21,651

(0.002)

Chow test Wald λ2 Adj (Pseudo) R2 N

(0.000) − 0.012⁎⁎⁎ (0.003) 0.001⁎⁎⁎ (0.000) − 0.000 (0.001) 0.003 (0.002) (0.000) 2911.4⁎⁎⁎ 0.08 16,595

1893.99⁎⁎⁎ 0.33 21,651

898.14⁎⁎⁎ (0.05) 16,595

Rep/TA

(0.001) 0.065⁎⁎⁎ (0.011)

Div/TA ROA ln(S) D/E %ΔTA M/B CFVol Age gGDP

Panel B. Interaction of governance and taxation on payouts Law × Imputation 0.025⁎⁎⁎ 0.053⁎⁎⁎ (0.001) (0.002) Law × TD 0.001⁎⁎⁎ − 0.002⁎⁎⁎ (0.000) (0.001) Controls YES YES 2 Wald λ 8007.6⁎⁎⁎ 11,429.45 Adj (Pseudo) R2 0.56 (0.26) N 38,618 38,618 ⁎⁎⁎ ⁎⁎ ⁎

− 0.010⁎⁎⁎ (0.000) 0.004⁎⁎⁎ (0.000) YES 29,712.28⁎⁎⁎ 0.36 38,618

− 0.016⁎⁎ (0.007) − 0.001 (0.003) YES 1563.94 (0.25) 38,618

Significantly different from zero at the 1% level between strong and weak protection using two-tailed t-tests. Significantly different from zero at the 5% level between strong and weak protection, using two-tailed t-tests. Significantly different from zero at the 10% level between strong and weak protection, using two-tailed t-tests.

after-tax return, implying that taxation on dividends makes managers use the excess cash more efficiently. These results are also in line with Chetty and Saez (2010) and Morck and Yeung (2005) who argue that lower dividend taxes mitigate the free cash flow problems since managers cannot use the tax burden of dividends as an excuse to hoard cash. However, in weak shareholder protection countries, the relationship between payouts and taxation is relatively weak. In columns (2) the coefficients of the dividend tax system are not significant and TD is negative, in contrast to the predictions of the tax effect. In column (2), all the tax variables are not significant. In the repurchases regressions, reported in columns (3) and (4), the tax variables are negative but not always significant. Moreover, cash dividends appear to be complementary, not substitutes, to share repurchases, as the coefficients of Rep/TA and Div/TA are positive and significant, suggesting that firms that pay cash dividends are also likely to repurchase their shares.

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In Panel B we assess the joint effects of shareholder protection and taxation on payouts by interacting investor protection Law with the imputation systems and with the tax differential ratio TD. For space considerations we group the full and partial imputation systems by a dummy variable, Imputation. We find that the interaction variable Law × Imputation is positive in cash dividend but negative in repurchases regressions, suggesting that firms that operate in strong protection and imputation systems pay higher cash dividends but repurchase less than other firms in the classical tax system and weak shareholder protection countries. However, the coefficient of Law × TD is not always as expected. Although it is positive and significant in Model (1), implying that firms that operate in high investor protection countries with high TD pay higher cash dividends, in line with the tax hypothesis, it becomes negative in Model (2), and positive in Model (3), suggesting that firms with high TD are more likely to repurchase shares.

4.4. Changes in dividends across dividend tax systems In this section we focus on the impact of taxation and shareholders protection on the decision to pay, increase and decrease cash dividends and repurchase shares. 14 We include in Table 6 the tax and governance variables as well as their interactions. The results show that firms that operate in the full and partial tax systems are more likely to pay dividends. TD is also positive suggesting that when shareholders are taxed less on dividends than capital gains, firms pay dividends, in line with Eije and Megginson (2008) who find positive effect of TD on the probability to pay dividends. However, Law is negative and insignificant, but Law × Imputation is positive and Repurchase × Imputation is negative, suggesting that firms that operate in an imputation tax system and in strong shareholder protection are more likely to pay dividends and less likely to repurchase stocks than their counterparts in other systems. The coefficients of TD × Imputation and TD × Law are not consistent with the tax hypothesis. The results for dividend increases and reductions are relatively similar and suggest that the interaction between shareholders protection and taxation affect significantly the decision to pay and to change cash dividend payments. However, the results are relatively weak for the decision to repurchase shares. The remaining variables are relatively consistent with previous studies. Dividend premium is not significant, and when it is, its sign is not as expected. Although, inconsistent with the catering theory (Baker and Wurgler, 2004), these results are in line with Hoberg and Prabhala (2009), Denis and Osobov (2008), and Eije and Megginson (2008) who show that dividend premium consistently carries the wrong sign. This result does not support Ferris et al. (2009) who find that, while in civil law countries, catering does not explain dividends, in common law countries shareholders extract dividends by putting a premium on dividend paying firms. Consistent with Fama and French (2001), M/B is negative in paying and increasing dividend and positive in dividends reducing regressions, in line with the need to fund growth. 15 In unreported results, we also find that 56% of our firms pay dividends. However, this proportion increases to 60% in the full compared to the remaining two systems. Similarly, while the average proportion of companies that increased their dividends during our sample period is 31%, it is higher in the partial and the full systems compared to the classical system. The probability of initiating dividends is also higher in the full, followed by the partial and it is the lowest in the classical system, while the proposition of firms that never paid dividends is the lowest in full imputation system, followed by the partial and then the classical system. However, the results for dividend cuts and omissions are not consistent with our tax hypothesis, as the probability of omitting or cutting dividends is significantly higher in the full system compared to the classical system.

5. Robustness checks In this section we assess whether our results are driven by our sample specifications and the measurements of our variables. Table 7 reports the tax and investors protection coefficients based on re-runs of the regressions in Table 5; Part I is for dividend and Part II is for repurchases. The remaining coefficients are not reported for space considerations. Panel A reports the sensitivity of our results with regards to the sample selection. Since U.S. firm/year observations represent 54%, 48%, and 27% in the classical, strong protection, and overall sample respectively, our results might suggest that the lower payout ratio in classical system countries is driven by the lower propensity to pay dividends in the U.S. (Fama and French, 2001), especially since in the other countries many firms still pay dividends (Denis and Osobov, 2008). To address this issue, we follow Brockman and Unlu (2009) and Ferreira et al. (2010) and re-run our regression without U.S. data. We also exclude the other two largest represented countries, UK and Japan. Our results are qualitatively similar, except that when we exclude UK or Japan, repurchases are independent of dividends in strong investor protection countries. In Panel B we use net income, sales and cash flow as denominators of payouts, and in Panel C we test for alternative measures of the Law variable by replacing the anti-self dealing index with the revised anti-directors rights index from Djankov et al. (2008), common law dummy, and the more recent corrected measure of anti-directors' rights of Spamann (2010). The results are qualitatively similar; they do not provide support to Djankov et al. (2008) who argue that anti-self dealing index provides a 14 The foreign exchange bias may affect our classification of firms as dividend increasing and cutting firms, as dividends may move up or down due to currency translation even if they do not change in local currency terms. We find the same qualitative results when we re-run our regressions using data measured in local currencies. 15 However, Denis and Osobov (2008) report negative impact of M/B on dividend changes, in U.S., Canada, and U.K. but positive in Germany, France, and Japan, and Chay and Su (2009) report positive or insignificant M/B coefficient in many countries.

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Table 6 Probit regressions for discrete dividend decisions. The table shows the likelihood of paying and changing dividends, and repurchasing shares, with country random effect. Full (Partial) system is a dummy equals 1 if the tax system is full (partial) imputation, and zero otherwise. Repurchase (Dividend) Dummy equals 1 if the firm repurchases shares (pays dividend) in year t, and zero otherwise. The remaining variables are as defined in Table 1. Robust standard errors are in parenthesis. Payout decision

Pay dividends

Increase dividends

Decrease dividends

Repurchase

Intercept

Partial system

− 2.520⁎⁎⁎ (0.227) 0.504⁎⁎ (0.256) 0.436⁎

− 2.814⁎⁎⁎ (0.193) 0.731⁎⁎⁎ (0.231) 0.714⁎⁎⁎

2.378⁎⁎⁎ (0.194) − 0.537⁎⁎ (0.233) − 0.536⁎⁎

0.022 (0.173) 1.244⁎⁎⁎ (0.199) 0.964⁎⁎⁎

TD

(0.256) 1.202⁎⁎⁎

(0.229) 0.884⁎⁎⁎ (0.134) 0.344 (0.272) 0.023 (0.083)

(0.231) − 0.897⁎⁎⁎ (0.135) − 0.463⁎ (0.276) − 0.031 (0.084)

(0.195) − 0.817⁎⁎⁎ (0.135) − 1.554⁎⁎⁎ (0.219)

Full system

LAW Repurchase dummy

(0.158) 0.491 (0.344) 0.129 (0.091)

Dividend dummy Law × Imputation Law × TD Repurchase × Imputation Repurchase × TD

0.943⁎⁎⁎ (0.358) − 0.985⁎⁎⁎ (0.209) − 0.241⁎⁎⁎

0.622⁎⁎ (0.270) − 0.558⁎⁎⁎ (0.187) − 0.309⁎⁎⁎

− 0.594⁎⁎ (0.275) 0.610⁎⁎⁎ (0.189) 0.260⁎⁎⁎

(0.036) 0.098 (0.099)

(0.034) 0.132 (0.091)

(0.030) − 0.133 (0.091)

− 0.445⁎ (0.245) 6.641⁎⁎⁎

− 0.728⁎⁎⁎ (0.219) 7.637⁎⁎⁎

(0.137) 0.288⁎⁎⁎ (0.006) − 0.330⁎⁎⁎

(0.156) 0.211⁎⁎⁎ (0.005) − 0.287⁎⁎⁎

0.561⁎⁎ (0.221) − 7.224⁎⁎⁎ (0.161) − 0.222⁎⁎⁎ (0.006) 0.344⁎⁎⁎

(0.196) 0.920⁎⁎⁎ (0.076) 0.047⁎⁎⁎ (0.005) 0.054⁎⁎⁎

(0.015) − 0.028⁎⁎⁎ (0.008) − 0.135⁎⁎⁎ (0.012) − 4.982⁎⁎⁎ (0.216) − 0.004 (0.011) 0.021⁎⁎⁎

(0.015) − 0.014⁎⁎ (0.006) − 0.156⁎⁎⁎ (0.011) − 4.232⁎⁎⁎ (0.217) − 0.001 (0.011) 0.009⁎⁎⁎

(0.016) 0.012⁎⁎ (0.006) 0.144⁎⁎⁎ (0.012) 5.427⁎⁎⁎ (0.232) 0.004 (0.011) − 0.009⁎⁎⁎

(0.013) − 0.614⁎⁎⁎ (0.024) − 0.116⁎⁎⁎ (0.009) − 0.017 (0.157) − 0.006 (0.009) 0.006⁎⁎⁎

(0.002) 0.432⁎⁎⁎ (0.133) − 0.077⁎⁎ (0.038) 8694.7⁎⁎⁎

(0.002) 0.349⁎⁎⁎ (0.111) 0.017 (0.033) 7080.6⁎⁎⁎

(0.002) − 0.350⁎⁎⁎ (0.114) − 0.008 (0.033) 7099.7⁎⁎⁎

(0.002) − 0.120 (0.083) − 0.039 (0.031) 2671.5⁎⁎⁎

38,618

38,618

38,618

38,618

Dividend × Imputation Dividend × TD TD × Imputation ROA Ln(S) D/E %ΔTA M/B CFVol gGDP Age Euro DP Wald Chisq N ⁎⁎⁎ ⁎⁎ ⁎

0.043 (0.080) − 0.238 (0.199) 1.521⁎⁎⁎ (0.176)

−0.638⁎⁎⁎ (0.032) 0.395⁎⁎⁎ (0.086) −0.730⁎⁎⁎

Significantly different from zero at the 1% level between strong and weak protection using two-tailed t-tests. Significantly different from zero at the 5% level between strong and weak protection, using two-tailed t-tests. Significantly different from zero at the 10% level between strong and weak protection, using two-tailed t-tests.

superior measurement for investor protection than anti-directors rights, they are consistent with La Porta et al. (2000b), and they suggest that they are not sensitive to governance proxies. In Panel D, we first check for the impact of ownership structure. Foreign (domestic) institutional investors are likely to have a negative (positive) impact on dividend payout, and large shareholders are likely to encourage dividend payments if they perceive dividends to have a lower tax cost. 16 Ferreira et al. (2010) show that foreign institutional investors press for fewer dividends since most countries impose a withholding tax on their dividends. Even if it is possible to credit those taxes against home country taxes, 16 Blouin et al. (2011) and Jacob and Jacob (forthcoming) show that in the presence of dividend tax disadvantage, the concentration of shareholders is likely to drive dividend increases.

M. Alzahrani, M. Lasfer / Journal of Corporate Finance 18 (2012) 745–762

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Table 7 Robustness checks: regressions of dividend and repurchases under various specifications for overall sample, and for strong and weak investor protection subsamples. The table presents re-runs of regressions in Tables 5 for dividends (Part I) and repurchases (Part II) and reports the coefficients of main repressors (Full, Partial, TD, Rep, Law × Imp, Law × TD). Panel A reports results for different samples that exclude US, UK, and Japan. Panel B reports results for different measures of the dependent variable, including dividends over earnings (NI), operating cash flows (CF) or sales (Part I), and repurchases over the sum of repurchases and dividends or repurchases over net income (Part II). In Panel C we use other measures for the Law variable, namely the anti-directors rights index from Djankov et al. (2008), a dummy that equals one if the company is originating in a common law country, and zero otherwise, or Spamann (2010) corrected measure of anti-director rights. Panel D includes ownership structure controls, such as country level total institutional ownership over total market capitalization, and an interaction term between the previous variable and a dummy that equals one if the proportion of foreign institutional investors is larger than 60%. We also add additional country specific institutional variables, namely risk of expropriation, creditor's rights, rule of law, stock market capitalization relative to GDP, and accounting disclosure quality, using data from La Porta et al. (1998). Part I. Cash dividends

Strong Full

Weak Partial

Panel A. Sample selection — the dependent variable Excluding US 0.021⁎⁎⁎ 0.006⁎⁎⁎ Excluding UK 0.021⁎⁎⁎ 0.006⁎⁎⁎ Excluding Japan 0.021⁎⁎⁎ 0.006⁎⁎⁎ Excluding All above 0.023⁎⁎⁎ 0.006⁎⁎⁎ Panel B. Definition of dependent variable Div/NI 0.307⁎⁎⁎ 0.089⁎⁎⁎ Div/NI No negative 0.329⁎⁎⁎ 0.105⁎⁎⁎ Div/Sales 0.025⁎⁎⁎ 0.008⁎⁎⁎ Div/CF 0.197⁎⁎⁎ 0.054⁎⁎⁎ Panel C. Definition of law variable — the dependent Anti-directors rights 0.021⁎⁎⁎ 0.006⁎⁎⁎ Common law dummy 0.021⁎⁎⁎ 0.006⁎⁎⁎ Correct anti-dir rights 0.010⁎⁎⁎ 0.009⁎⁎⁎

TD

Full

Partial

TD

Rep

Law × Imp

Law × TD

is Div/TA 0.006⁎⁎⁎ 0.004⁎⁎⁎ 0.004⁎⁎⁎ 0.006⁎⁎⁎

− 0.012⁎⁎⁎ − 0.001 − 0.001 − 0.019⁎⁎⁎

0.000 0.000 0.001 0.001

0.001 0.001 0.001 0.001

− 0.002⁎⁎ − 0.002⁎⁎ − 0.003 − 0.002

0.008⁎⁎⁎ 0.009⁎⁎⁎ 0.008⁎⁎⁎ 0.008⁎⁎⁎

0.027⁎⁎⁎ 0.034⁎⁎⁎ 0.028⁎⁎⁎ 0.031⁎⁎⁎

0.012⁎⁎⁎ 0.006⁎⁎⁎ 0.005⁎⁎⁎ 0.018⁎⁎⁎

0.078⁎⁎⁎ 0.073⁎⁎⁎ 0.010⁎⁎⁎ 0.044⁎⁎

− 0.519⁎⁎⁎ − 0.616⁎⁎⁎ 0.005 − 0.153⁎⁎⁎

0.017 0.027 0.002 0.012

0.010 0.018 0.004 0.028⁎⁎

− 0.026 − 0.183⁎⁎ − 0.000 0.020

0.485⁎ 0.778⁎⁎⁎ 0.111⁎⁎⁎ − 0.003

0.415⁎⁎⁎ 0.464⁎⁎⁎ 0.021⁎⁎⁎ 0.219⁎⁎⁎

0.052⁎⁎⁎ 0.092⁎⁎⁎ 0.001 0.038⁎⁎⁎

0.000 0.000 0.001

0.002 0.001 0.003⁎⁎

− 0.002 − 0.002⁎⁎ − 0.000

0.009⁎⁎⁎ 0.009⁎⁎⁎ 0.008⁎

0.004⁎⁎⁎ 0.005⁎⁎⁎ 0.002⁎⁎⁎

0.007⁎⁎⁎ 0.001⁎ 0.009⁎⁎⁎

− 0.004⁎⁎⁎ 0.004⁎⁎⁎

− 0.002⁎⁎⁎ 0.005⁎⁎⁎

0.004⁎⁎⁎ 0.006⁎⁎⁎

0.009⁎⁎⁎ 0.008⁎⁎⁎

0.026⁎⁎⁎ 0.009⁎⁎⁎

0.000 0.007

variable is Div/TA 0.006⁎⁎⁎ − 0.004⁎ 0.003⁎⁎⁎ − 0.001 0.008⁎⁎⁎ 0.001

Panel D. Additional control variables — the dependent variable is Div/TA Ownership structure 0.022⁎⁎⁎ 0.009⁎⁎⁎ 0.003⁎⁎⁎ 0.000 Country specific 0.014⁎⁎⁎ 0.020⁎⁎⁎ 0.003⁎ 0.001 Part II. Share repurchases

Strong Full

All

Rep

Weak Partial

Dividend

Full

Partial

TD

Dividend

Law × Imp

Law × TD

0.000 − 0.003⁎⁎⁎

− 0.001⁎⁎ − 0.001⁎⁎⁎ − 0.001⁎⁎⁎ − 0.001⁎⁎

− 0.001⁎⁎⁎ − 0.001⁎⁎⁎ − 0.003⁎⁎⁎ − 0.003⁎⁎⁎

− 0.003⁎⁎⁎ − 0.003⁎⁎⁎ − 0.004⁎⁎⁎ − 0.004⁎⁎⁎

− 0.004⁎⁎⁎ − 0.004⁎⁎⁎ − 0.001⁎ − 0.001⁎

0.001⁎⁎⁎ 0.001⁎⁎⁎ 0.001⁎⁎ 0.001⁎⁎

− 0.004⁎⁎⁎ − 0.015⁎⁎⁎ − 0.006⁎⁎⁎ − 0.004⁎⁎⁎

0.002⁎⁎⁎ 0.001 0.001 0.002⁎

− 0.007 0.001 0.007

− 2.772⁎⁎⁎ − 0.029 − 0.039

0.013 − 0.006⁎ − 0.002

− 0.006 − 0.003 − 0.002

− 0.139⁎⁎⁎ − 0.003 − 0.009⁎

− 2.522⁎⁎⁎ 0.163⁎⁎⁎ 0.106⁎⁎⁎

− 0.016⁎⁎⁎ − 0.014⁎⁎⁎ − 0.015⁎⁎⁎

0.012⁎⁎⁎ 0.009⁎⁎⁎ 0.008⁎⁎⁎

variable is Rep/TA 0.000 − 0.000 0.001 − 0.001⁎⁎⁎ − 0.005⁎⁎⁎ 0.004⁎⁎⁎

− 0.003⁎⁎⁎ − 0.001⁎⁎⁎ − 0.003⁎⁎⁎

− 0.004⁎⁎⁎ − 0.003⁎⁎⁎ − 0.003⁎⁎⁎

0.005⁎⁎⁎ − 0.003⁎⁎⁎ 0.002⁎

− 0.000 0.000⁎ 0.027⁎⁎⁎

− 0.001 − 0.005⁎⁎⁎ 0.003

− 0.003⁎⁎⁎ 0.005⁎⁎⁎ − 0.003⁎⁎⁎

Panel D. Additional control variables — the dependent variable is Rep/TA Ownership structure − 0.005⁎⁎⁎ − 0.003⁎⁎⁎ 0.005⁎⁎⁎ − 0.001⁎⁎⁎ Country specific − 0.005⁎⁎⁎ − 0.002 0.005⁎⁎⁎ − 0.001⁎⁎⁎

− 0.003⁎⁎⁎ − 0.002⁎⁎⁎

− 0.004⁎⁎⁎ − 0.003⁎⁎⁎

− 0.000 − 0.000

0.000 0.000

− 0.002 − 0.022⁎⁎⁎

0.004 0.012⁎⁎⁎

Panel A. Sample selection — the dependent variable Excluding US 0.003⁎⁎⁎ 0.003⁎⁎⁎ Excluding UK − 0.005⁎⁎⁎ − 0.005⁎⁎⁎ Excluding Japan − 0.005⁎⁎⁎ − 0.004⁎⁎⁎ Excluding All above 0.004⁎⁎⁎ 0.005⁎⁎⁎ Panel B. Definition of dependent variable Rep/(Rep + Div) − 0.055⁎⁎⁎ − 0.044⁎⁎⁎ Rep/NI − 0.011⁎⁎⁎ − 0.009⁎⁎⁎ Rep/NI No negative − 0.011⁎⁎⁎ − 0.011⁎⁎⁎ Panel C. Definition of law variable — the dependent Anti-directors Rights − 0.002⁎⁎⁎ − 0.001⁎⁎⁎ Common law dummy − 0.004⁎⁎⁎ − 0.004⁎⁎⁎ Correct anti-dir rights − 0.001⁎⁎ − 0.001⁎

TD

All

is Rep/TA − 0.001 − 0.004⁎⁎⁎

⁎⁎⁎ ⁎⁎ ⁎

Significantly different from zero at the 1% level between strong and weak protection using two-tailed t-tests. Significantly different from zero at the 5% level between strong and weak protection, using two-tailed t-tests. Significantly different from zero at the 10% level between strong and weak protection, using two-tailed t-tests.

many institutional investors are tax exempt and cannot take advantage of such credit. Unlike foreign institutional investors, local institutional investors are expected to press for higher payout to mitigate agency and information asymmetry costs. We, thus, add country level percentage of total institutional ownership relative to total market capitalization. We also include an interaction term between the first variable and a dummy that equals one if the proportion of foreign institutional investors is larger than 60% (the sample mean). Using the institutional ownership data used by Ferreira et al. (2010), we find that foreign institutional ownership is lower in classical system countries (correlation −0.49), while domestic institutional ownership is higher in those countries (correlation 0.56). We find the opposite in full and partial system countries where the correlations between full and partial system dummies with foreign institutional ownership are 0.10 and 0.45, respectively, but their respective correlations with domestic institutional ownership are − 0.31 and − 0.35. These results imply country level dividend clienteles as foreign

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investors prefer countries with tax relief. We also control for country level ownership concentration measured by the average percentage ownership of the top three shareholders in the ten largest non-financial, privately-owned domestic firms in a given country using La Porta et al. (2006) data. The results in Panel D did not change significantly. In unreported results, we find a positive and significant coefficient for ownership concentration, consistent with Michaely and Roberts (2012) and in line with the proposition that large shareholders monitor managers and reduce the agency cost of free cash flow (Shleifer and Vishny, 1986). In line with Ferreira et al. (2010), we also find, but do not report, that institutional ownership variable is positive and significant, while the foreign ownership dummy is negative and significant when we exclude the U.S. data in the dividend regression. When we include U.S. data, both variables are negative and foreign dummy is insignificant. In the repurchases equation, the two institutional ownership variables are positive and significant, suggesting that foreign institutional investors are more disadvantaged with dividends than repurchases. Finally, we control for several country specific variables that are shown to have an effect on payout policy to insure that our results are not biased because of omitted variables. We add risk of expropriation as firms in high expropriation risk countries are encouraged to hold less liquid assets and payout more cash to reduce the chances of expropriation (Faccio et al., 2001). We also include creditors' rights as countries with poor creditors rights are expected to have lower payout to substitute for such weak rights (Brockman and Unlu, 2009). We also include rule of law as countries with higher scores are expected to have higher dividends based on the outcome model (La Porta et al., 2000b). We control for stock market development, measured as stock market capitalization relative to GDP, as firms in countries with less developed stock markets are more likely to pay lower dividends and accumulate more cash. Finally, we account for accounting disclosure quality as it affects payout policy (Brockman and Unlu, 2008). The data on all these variables is extracted from La Porta et al. (1998). The results, reported in Panel D, did not change significantly. The last two columns in Table 7 report the coefficient of the interaction between taxation and governance. In Part I. the Law × Imputation is constantly positive and significant, suggesting that firms in high investor protection with imputation system pay significantly higher cash dividends. Similarly, the variable Law × TD is also positive and significant, except when dividend is scaled by sales and when we introduce ownership structure and country specific factors, in Panel D. However, Part II shows that the impact of these two interaction variables on share repurchases is relatively weak. Although Law × Imputation is negative and significant in most repurchase regressions, in line with the tax hypothesis, Law × TD is negative and consistent with the tax effect only when we use anti-directors' rights and Spamann's (2010) correct anti-directors' rights. 6. Conclusions and discussions We analyze the impact of investor protection and taxation on the payout policy of firms listed in 24 OECD member countries. We reassess previous evidence that firms in high investor protection countries pay higher dividends in the presence of tax costs of dividends. More specifically, we examine whether governance per se or the combination of governance and taxation that makes firms pay or change their dividends. Under the outcome model in La Porta et al. (2000b), we expect minority shareholders in strong investor protection countries to use their stronger rights to obtain higher cash dividends when dividend tax is low, but when the dividend tax is high, they will demand their firms to opt for the more tax-efficient share repurchases. In contrast the substitute hypothesis suggests that managers in strong investor protection countries are less likely to pay dividends as they have less need to build reputation or mitigate the agency conflicts. In this case, dividends will be small, only paid to build reputation, and insensitive to taxes. Conversely, in weak investor protection countries, the outcome model in La Porta et al. (2000b) predicts that managers will refrain from paying cash dividends or repurchasing shares to consume private benefits. Investors would request the more taxefficient repurchases, but since they have less power to choose the method of payment, they accept the less tax-efficient dividends when the benefits of reducing the cost of expropriation of minority shareholders outweigh the tax cost of dividends. Similarly, under the substitution hypothesis, managers need to pay dividends to establish reputation, particularly for raising future capital, regardless of their tax consequences. These two hypotheses suggest that taxation will have a weak or no effect on dividends in weak investor protection countries. We find that the combination of governance and taxation are more likely to affect the firm's payouts. We show that firms in high investor protection countries pay higher dividends, but the distribution of payouts across tax systems is not homogeneous. In the classical tax system, firms in strong investor protection countries pay significantly lower dividends, but they repurchase more shares, than their counterparts in weak investor protection countries; and as the tax cost of dividends decreases, they pay higher dividends but repurchase fewer shares. However, in weak investor protection countries the impact of taxation is weak. Our overall results suggest that in strong protection countries, shareholders accept less dividends and more repurchases when the tax cost of dividend outweigh the benefit of reducing the agency cost; and managers maximise their shareholders' after-tax return by substituting cash dividends for repurchases. In contrast, in weak investor protection countries, managers appear to be able to set dividend policies that are independent of tax costs as governance is poor and investors aim at extracting cash than optimizing after-tax return. The agency theory suggests that dividends are a manifestation of shareholders' wealth maximization by managers, and, thus, the more aligned the objectives of managers with those of shareholders, the higher the payout (e.g., Desai et al., 2007; Fenn and Liang, 2001; La Porta et al., 2000b). Our results are consistent with these arguments and support the outcome model. Particularly, when investor protection increases, the manager pays more dividends when they suffer no (or less) tax disadvantage, while she pays less dividends when they carry a tax disadvantage that reduces the wealth of shareholders. In addition, the lack of tax impact

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in weak governance countries also supports the outcome model that managers in those countries, not only pay low dividends, but ignore the tax disadvantages assumed by their investors. They can get away with such practice because investors' rights are not well protected and shareholders are more concerned about extracting cash than about the tax consequences of such extraction. These results provide additional perspectives to the outcome model and the agency explanation of dividends and show that the interrelation between agency and taxation explains dividend payouts. Our analysis may suffer from a number of limitations beyond our control. While the definitions of tax systems, Classical, Partial and Full are relatively unambiguous, the measurement of the tax differential ratio TD may be subject to errors. Because of data unavailability, we base TD on the top statutory rather than effective tax rates of marginal investors. In addition to the complexity of identifying the marginal investor and measuring her effective tax rates, the statutory rates are also less representative because of dividend tax clientele and the ability of investors to avoid dividend taxes by investing through tax-exempt entities or hold their investments in a tax-exempt account. All these factors can lead to weaker TD, as argued by Graham (2008), and thus might contribute to our reported weak effects of TD. Moreover, we assume that firms are subject to taxes of their country of registration and quotation, while many firms are international and may pay dividends from their foreign income. Firms may also have other ways of managing their tax liability, particularly if they operate internationally. In addition, firms may have different governance systems, accounting standards and dividend clienteles than those in their home country. 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