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Taxes and dividend policy
TAXES AND DIVIDEND POLICY
CHUNCHI
WU
ABSTRACT This paper examines the effect of differential personal taxation on corporate dividend policy. The temporal pattern of corporate dividend payout and dynamic dividend behavior are examined over a period with significant changes in the tax code. The paper finds that there are structural shifts in the aggregate dividend payout and these shifts often coincide with tax law changes. The empirical results provide a modest support for the hypothesis that the elimination of the preferential capital gains tax treatment in 1986 has a positive impact on the aggregate corporate dividend payout ratio.
I.
INTRODUCTION
Financial theory has suggested that taxes affect corporate dividend policy (Farrar & Selwyn, 1969; Brennan, 1970; Masulis & Trueman, 1988). If this theory is correct, we should observe changes in corporate dividend payout whenever the government changes its income tax policy. However, Miller and Scholes (1978, 1982) have shown that dividend income could, to a large extent, be sheltered from taxation. Therefore, the effect of taxes on corporate dividend policy depends on the extent to which individuals can elude taxes. If individuals and institutions can successfully reduce the tax burden, the effect of taxes on corporate dividend policy would be minimal. Previous studies (Peterson, Peterson, & Ang, 198.5; Chaplinsky & Seyhun, 1990) have shown that individuals can reduce some but not all tax liability. Recently, Bolster and Janjigian (1991) and Papaioannou and Savarese (1994) examine the effect of the 1986 tax reform on corporate dividend policy and report Direct
all correspondence
to:
Chunchi
Wu, School
of Management,
Syracuse
University,
Syracuse,
NY
13244. International Review of Economics ISSN: 1059-0560
and Finance, S(3): 291-305 Copyright 0 1996 by JAI Press Inc. All rights of reproduction in any form reserved.
291
292
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conflicting results.’ The controversial evidence for the impact of taxes on corporate dividend policy suggest the need for a further examination of this issue. In this paper, we analyze the temporal pattern of aggregate dividend behavior to shed more light on the effect of taxes on dividend policy. The purpose of this paper is to examine the effect of changes in capital gains and income taxes on corporate dividend policy. We measure the extent of the tax effect on dividend policy from two different aspects. First, we analyze the intertemporal pattern of dividends to see whether dividend payout ratios are sensitive to changes in income taxes. In this analysis, we attempt to detect whether there is a significant shift in corporate dividend payout surrounding the years with changes in the income tax code. Second, we examine time variations of the parameters of the dynamic dividend models to detect whether there are structural shifts in corporate dividend behavior as a result of changes in taxes. The tax factor may affect the firm’s target dividend payout ratio and the dynamic adjustment pattern of dividends. If so, the parameters and the structure of the dynamic dividend models may change. An examination of the parameter and the structure of dividend models provides some clues to the effect of taxes on dividend policy. Our analysis focuses on the aggregate dividend behavior. The aggregate analysis allows us to assess the overall impact of taxation on dividends while bypassing the complicated issue of information signalling. The present study focuses on the impacts of tax reforms on the temporal pattern of corporate dividend payout and dynamic dividend behavior. This approach contrasts previous studies on dividends and taxes that emphasize individuals’ tax reduction strategies (Miller & Scholes, 1978; Chaplinsky and Seyhun, 1990). Our analysis shed more light on the role of taxes in the determination of corporate income distribution and dynamic dividend adjustment. Furthermore, we study the effects of tax reforms in recent years which were not covered by previous studies. The remainder of this paper is organized as follows. Section 2 discusses the relationship between taxes and dividend policy. Section 3 describes the empirical methodology while Section 4 discusses data and empirical results. Finally, Section 5 summarizes the findings.
II.
DIVIDENDS
AND TAXES
Miller and Modigliani (1961) argue that dividend policy is irrelevant for the cost of capital and the value of the firm in a world without taxes or transaction costs. They show that when investors can create any income pattern by selling and buying shares, the expected return required to induce them to hold firm shares will be invariant to the way the firm packages dividend payments and new issues of stocks. Since the firm’s assets, investment opportunities, expected future net cash flows and cost of capital are not affected by the choice of dividend policy, its market value is unaffected by any change in the firm’s payout pattern. Thus, dividend policy is irrelevant and firms can choose any payout pattern without affecting their value. Miller and Modigliani’s (MM) theory implies that dividend payout will fluctuate as a by-product of the firm’s investment and financing decisions, and therefore, will not exhibit a systematic pattern over time. MM’s irrelevance argument also applies to the case with corporate taxes but without personal taxes. It can be shown that the value of firms with or without debts is not affected by
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Taxes and Dividend Policy
dividend policy if there are no transaction costs and investment decisions are independent of dividend decisions. The situation becomes more complicated when personal taxes are considered. In general, dividend policy becomes relevant if investors’ dividend income tax rates are higher than their capital gains tax rates. However, Federal tax laws are complex and individuals can shelter their income through tax-exempt and tax-deferred investments. Also, reducing the tax liability of dividend income often involves transaction costs. The existence of transaction costs may preclude individuals from fully using tax-reduction strategies. Despite these complications, dividends generally subject individual investors to a higher income tax rate than capital gains do. Thus, dividend policy may affect investors’ after-tax income and therefore, the cost of capital and the value of the firm. As Brennan (1970) indicates, for a given risk level, investors require a higher total return on a security, the higher its prospective dividend yield is, if a higher tax rate is levied on dividends than on capital gains. Therefore, from the standpoint of maximizing individuals’ net after-tax income, firms should pay the lowest cash dividends to reduce shareholders’ tax burden. If taxes are relevant to the firm’s value and cost of capital, we should observe a change in corporate dividend policy whenever there is a change in personal income and/or capital gains taxes. Firms and investors are expected to respond to the change in the tax code in making their dividend and investment decisions. For instance, when there is a decrease in the capital gains tax rate relative to the regular income tax rate, firms should reduce their dividend payout, and vice versa. The tax laws in the U.S. have gone through a couple of changes since 1980. In 1981, we had the largest tax cuts in the history of the United States. Top individual tax rates decreased from 70 to 50 percent and allowable contributions to Keoghs and other retirement systems were increased. The Tax Reform Act of 1984 lowered the holding period on capital gains from more than one year to more than six months, while the minimum holding period for the 85% exclusion for corporate investors was extended from 16 to 46 days. In 1986, the most sweeping revision of the tax code in the U.S. history took place. One of the most significant changes in 1986 is the elimination of the preferential tax treatment of long-term capital gains. An important question is whether these changes in tax laws have affected corporate dividend policy. To examine the effects of changes in tax laws on corporate dividend policy, we first analyze shareholders’ after-tax income under differential taxes. We assume that there are corporate and personal debts and the tax rates for capital gains and dividends are different. Also, for simplicity, assume that the firm’s net after-tax income is positive and the borrowing rate is equal for the firm and the shareholder.2 If the firm pays out all its cash flows as dividends, the shareholder will receive the following after-tax income $: Yd =
[(Y- iD,)( 1 - tJ - iD,](l - t&J
(1)
where Yd = the shareholder’s after-tax income dividends Y = the firm’s net operating income
if corporate
income
is distributed
totally
as
294
i= tc = tp = D, = Dp =
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the borrowing rate the corporate income tax rate the personal income tax rate corporate debt, and personal debt.
Alternatively, if the firm pays no dividends the shareholder’s after-tax income is F = (Y- iD,)(l
to let the shareholder realize capital gains, then
- t,)(l - tg) - iD,,(l - tp)
(2)
where k’s = the shareholder’s tg = the shareholder’s
after-tax income if the firm does not pay dividends capital gains tax rate.
The shareholder’s after-tax income is greater when the firm pays no dividends, that is, PTplyd> 1 if the capital gains tax rate is lower than the regular income tax rate. Two types of changes in personal taxes can affect the shareholder’s after-tax income. First, an increase in the capital gains tax rate, relative to the regular income tax rate, reduces the ratio YRlyd. In the special case where the capital gains tax rate is equal to the regular income tax rate, the ratio becomes one. Second, an across-the-board increase in personal income tax rates, if the capital gains rate is a percentage (p) of the regular income tax rate, raises the ratio Pl@. It can be shown that
a( YVf> at,
(1 -P)W-iD,)(l-$)I = [(Y-iD,)(1-tc,-iDpl(l-$)2
>.
(3)
The effect of tp on Plyd is positive because any increase in the regular income tax rate widens the difference between the capital gains and the regular income taxes. Conversely, a decrease in the income tax rate (as in 1981) will narrow the gap between the capital gains and regular income taxes. A change in the capital gains tax rate relative to the regular income tax rate should affect corporate dividend payout if the tax theory of dividends is correct. To that extent, we should observe changes in aggregate payout ratios around the tax reform years. The past decade provides an excellent opportunity for tracking the temporal effect of taxes on dividend policy because several unprecedented tax reforms were introduced in this period. In the following, we discuss the empirical methodology.
III.
EMPIRICAL
METHODOLOGY
To assess the effect of changes in taxes, we analyze the dividend payout pattern over a period with major tax reforms. In addition, we examine firms dynamic dividend behavior and see how they respond to tax law changes.
Taxes and Dividend
295
Policy
A.
/ntertempora/
Dividend
Payout
A direct analysis of the tax effect is to examine the intertemporal pattern of dividend payout to see whether there are significant changes in payout ratios around the years with income tax changes. Two measures of dividend payout are used in this analysis. The first payout measure is dividends divided by earnings (D/E). This is the type of payout ratio usually defined in the traditional financial analysis. The second payout measure is dividends divided by stock price (D/P). In this alternative measure, we assume that stock price is equal to the intrinsic value of the firm or the present value of expected future cash flows available to existing stockholders. Finance literature has suggested that stock price contains information about the firm’s permanent earnings (Marsh & Merton, 1987; Beaver, Lambert, & Ryan, 1987). Assuming that the required rate of return (a) for the firm is constant, the firm’s permanent earnings can be set equal to aP, the perceived returns on the intrinsic value of the firm. Thus, the D/P ratio is theoretically equal to l/a times the longterm payout ratio (dividends divided by permanent earnings). Changes in D/P therefore provide valuable information for changes in corporate payout policy. To analyze the intertemporal behavior of corporate dividends, we propose the following linear regression model:
z, = m
+ I_+
(4)
where Z, = the dividend payout measure (D/E or D/P) m = the mean of Z, and -ot - N(0, o*) is the disturbance term. We then apply the tests of structural changes proposed by Brown, Durbin and Evans (1975) to the above linear model. Brown, Durbin and Evans (1975) show that the residuals from recursive regressions contain useful information for detecting structural changes over time. They suggest CUSUM and CUSUM-square tests for detecting such changes. Let X = (xt, x2, . ... x,)‘, where xP j = 1, 2, 3 ,..., IZare the observation of the independent variables (including the intercept term) at time j and n equals the number of observations. The orders of X and Xj are nxk and krl, respectively, where k is the number of explanatory variables in the regression, which is equal to one in the present case. Then, the recursive residual of the regression model based on the first r observations is
w, =
Zr-xr’mr-
1
(5) (1 +xr’(XJ_J1x,)
where r = 2, 3, . ... n and wt - N(0, o*). The CUSUM and CUSUM-square defined as
w, = f
i j=k+l
wj
test statistics are
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(7)
where s is the sample estimate of the standard deviation (T. A series of these parameter estimates can be generated by a recursive estimation procedure. We initially estimate the model using the first k + 1 observations, and then expand the sample to include the next observation. This procedure is repeated until all the observations in the sample are exhausted. If taxes are indeed an important determinant of corporate dividend policy, we should observe a significant structural shift around the time of a major tax reform. To detect such a structural shift, we construct the CUSUM and CUSUM-square test statistics. Under the null hypothesis, the means of these two statistics are 0 and (I - k)l(n - k), where r= k+ 1, .... n, is the number of data points included in the estimation and II is the total observations in the sample. Brown, Durbin and Evans (1975) provide cutoff values for different statistical confidence levels. Details about the test procedure are described in the Appendix.
B.
Dynamic
Dividend
Adjustment
Previous studies (Lintner, 1956; Fama & Babiak, 1968; Brittain, 1966; Marsh & Merton, 1987; Lee, Wu & Djarraya, 1987; Kao & Wu, 1994a, 1994b) have suggested that corporate dividend behavior follows a dynamic adjustment process. If taxes are relevant, changes in the tax law will affect the firm’s (desired) target payout ratio and possibly the dividend adjustment pattern also. Either of these two effects can cause a shift in the structure of the dividend adjustment model. Therefore, an alternative way for examining the tax effects is to detect whether there is a significant change in the dynamic dividend behavior surrounding the time with changes in the tax code. We consider two dividend models. The first is Lintner’s partial adjustment model:
D,-D,-
1 =
h(D;-D,_,)+u,
(8)
where 0; is the desired dividend level, his the speed-of-adjustment coefficient and uI is the disturbance term. The desired dividend is traditionally related to reported earnings Et. For instance, Lintner set the desired dividend to yEl where y is the long-term payout ratio. However, reported earnings may not represent the true long-term permanent earnings of the firm. To remedy this problem, we also use stock price as a proxy for permanent earnings and set the desired dividend to y*P, where ‘y*equals ay, and a is the required rate of returns. The second dividend model is suggested by Marsh and Merton ( 1987):3
log(D,+ ,/D,) =
a0 +
~logWt + D,)/P,_ 1l -Glog(D,/P,_ ,I = q+
1
(9)
where a0 = the constant term h = the speed-of-adjustment parameter 6 = the coefficient of error-correction that drags short-run dividends toward the longrun payout ratio
Taxes and Dividend Policy
297
D, = the firm’s dividend at time t P, = the firm’s stock price at time t, and Et + 1 = the disturbance term at time t + 1. The Marsh-Merton model imposes a long-run steady-state condition for the target dividend payout on the short-run dividend dynamics.4 A series of parameter estimates for the dividend models can be generated by the CUSUM recursive procedure. Similar to the analysis of intertemporal dividend payout, the CUSUM and CUSUM-square tests of the structural changes can be applied. The test statistics will provide an indication whether there is a significant structural change in the corporate dividend behavior when the tax law changes.
IV.
DATA AND EMPIRICAL
RESULTS
Aggregate quarterly dividends, prices and earnings data were collected from the COMPUSTAT PDE tape. The COMPUSTAT tape contains quarterly dividends, prices and earnings for major market indexes. We select S&P 500 and 400 indexes for our study. The S&P 500 composite index includes utilities which are regulated firms adopting somewhat different dividend policy. The composition of the S&P 500 index is usually less consistent than that of the 400 index. We choose both indexes for comparison because the temporal behavior of these two indexes may be different. Major changes in the tax code are reported by Internal Revenue Service Statistics of Income. The IRS reports allow us to identify the years of significant changes in income and capital gains taxes. The study period covers 1965-91. The selection of a longer sample period increases the degree of freedom and reduces the sensitivity of parameter estimates to the sample size. Among the major tax law changes since 1965, we are particularly interested in the impact of the 1986 tax reform. Table 1 reports the results of CUSUM and CUSUM-square tests for dividend yields (D/P). The tests are performed recursively forward and recursively backward based on equation (4). The tests indicate that there are four shifts in the D/P ratio for the period 1965-91. These shifts occur in the years of 1970, 1978, 1982, and 1986. There were major changes in the tax code for capital gains and income taxes in 1978 and 1986. The Revenue Act of 1978 reduced corporate income taxes and changed tax shelter rules. The 1986 Tax Reform Act eliminated the preferential tax rate for capital gains. The rise in the capital gains tax rate after 1986 increases the relative value of dividends to investors. As a result, firms may have an incentive to distribute more income as dividends. The results of recursive estimation show that there is a significant increase in the D/P ratio in the late 1986 and early 1987. Thus, there appears to be a correlation between corporate dividend payout and income tax changes. Table 2 reports the results for the D/E ratio. The CUSUM and CUSUM-square tests identify five major shifts. These shifts occur in 1971, 1976, 1977, 1988, and 1989. The shift in 1971 might be due to external shocks associated with oil crisis and price freeze. In 1977, the Tax Reduction and Simplification Act was introduced. The shifts in 1988 and 1989 could be associated with the 1986 tax law change. Although the Tax Reform Act was introduced in 1986, the year of 1987 is a transitional period. The full implementation of the tax reform took place in 1988. Therefore, the significant shifts (increases) in the D/E
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CHUNCHI Table 1.
Structural Shifts in Temporal Dividend-Price (D/P), = 171 + 2),
S&P 500 Index Quarterly
CUSUM
D/P (1965:1-1991:4)
CUSUM SQUARE
S&P 400 Index Quarterly
Years and Qtrs
Forward _ Backward
1978: 1 1982:2
Forward
1970:3
Backward
1986:3
Forward
1978:4
Backward
1982:2
Forward
1970:3
Backward
1986:3
CUSUM
D/P (1965:lL1991:4)
Table 2.
Ratios
Tests
Data
WU
CUSUM SQUARE
Structural Shifts in Temporal Dividend-Earnings
Ratios
(D/E), = m + 2),
S&P 500 Index Quarterly DiE (1965:lL1991:4)
S&P 400 Index Quarterly D/E (1965:1-1991:4)
Yam
Tests
D&2
and Qtrs
Forward
1977: 1
Backward
1989:2
CUSUM CUSUM SQUARE
Forward
1971:l
Backward
1988:3
Forward
1976:2
Backward
19x9:3
Forward
1971:2
CUSUM
/
I
CUSUM SQUARE I
Backward
I
1988:3
ratio for the years 1988 and 1989 may be due to the 1986 tax law change. These increases in the D/E ratio are consistent with the tax theory of dividends which predicts an increase in dividend payout as the capital gains tax rate rises. The increases in the D/E ratio is much stronger than the increases in the D/P ratio after 1986. It is possible that increases in the D/ E ratio after 1986 are affected by short-term fluctuations in the reported earnings figures. To smooth out the effect of short-term cyclical earnings fluctuations, we also performed the tests using three-years moving averages of earnings figures. It is interesting to note that the results based on the smoothed data exhibit a similar pattern as in Table 2. Figures la and 1b present the plots of temporal D/E ratios estimated recursively forward and backward for S&P 400 and S&P 500 indexes. The D/E ratios for both 500 and 400 indexes are quite stable for most of the study period. The results show a significant upward shift in the D/E ratio after 1987, which is confirmed by both the CUSUM and CUSUMsquare tests. The results of the CUSUM estimation refect the pattern of the underlying temporal D/E series. The historical dividend payout ratios for the S&P 500 (S&P 400) index increase from about 38% (39%) in 1986 to 67% (69%) in 1989. During this period, the CUSUM backward estimates of dividend payout ratios for the S&P 500 (S&P 400) index increase from 55% (50%) to 60% (56%).
Taxes
and
Dividend
299
Policy
Figure la.
Plot of CUSUM Estimates of S&P 500 D/E Ratios
0.75 I
P
0.7 0.65 0.6 0.55 0.5 0.45
Figure I b.
Plot of CUSUM Estimates of S&P 400 D/E Ratios
0.75 0.7
I
t
0.65 0.6 0.55 0.5 0.45
Figure 1.
Plot of CUSUM Estimates of Dividends
Payout Ratios (1965:1-1991:4)
Figures 2a and 2b show the plots of temporal D/P ratios estimated recursively forward and backward for the 500 and 400 indexes. The results for both indexes exhibit a similar pattern. The backward estimations indicate a short-term upward shift of the dividend payout in late 1986. This upward shift is also confirmed by both the CUSUM and CUSUMsquare tests. The CUSUM estimates of dividend yields for the S&P 500 (400) index increase from 0.0081 (0.0071) in 1986 to 0.0086 (0.0077) in 1988. It is also worth noting that historical dividend yields exhibit variations. The mean dividend yield of the S&P 500 index is around 0.008 before 1973. The mean dividend yield increases to 0.013 between
300
CHUNCHI Figure 2a.
Plot of CUSUM Estimates of S&P 500 D/P Ratios
Figure 2a.
Plot of CUSUM Estimates of S&P 400 D/P Ratios
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0.011
0.0105 0.01 0.0095 0.009 0.0085 0.008 0.0075
Figure 2.
Plot of CUSUM Estimates of Dividends
Yields (1965: l-1 99 1:4)
1973 and 1982. It then drops to 0.009 after 1982. Dividend yields appear to be affected by other economic factors.5 Nevertheless, a short-term shift in dividend yields is identified by the CUSUM tests in 1986, which is associated with the 1986 tax refotm6 In summary, the results above suggest that there is an upward shift in the aggregate corporate dividend payout after the 1986 tax reform. This shift may be attributed to the elimination of the favorable capital gains tax treatment after 1986. Also, there is a slight difference between the timing of shifts for the D/P and D/E ratios. The shift in the D/P ratio occurs in 1986, while the shifts in the D/E ratio occur after 1987. This discrepancy may be
Taxes and Dividend
301
Policy
Tubk 3. log@, + IQ)
Structural
Shifts in Dynamic Dividend
= oo + hlog[(P, + D,)lP, - 11- ~log(q&
S&P 500 Index Quarterly Data (1965:1-1991:4)
S&P 400 Index Quarterly Data (1965:1-1991:4)
CUSUM CUSUM SQUARE
_~
- 1) + Et, 1 Yeur.s and Qrrs
Tests
D&t
Behavior
Forward ~____~ Backward
1978:4 -
Forward
1974:2
Backward
1981:4
Forward
-
CUSUM Backward CUSUM SQUARE
Forward
1977:2
Backward
1981:3
due to the fact that stock price reacts more quickly to changes in the tax law, whereas it takes longer time for companies to alter the dividend payout ratio. It may also possibly be related to the fact that the full scale effect of the 1986 tax reform took place in 1988 or later. Therefore, the time series of D/P and D/E might exhibit somewhat different patterns. To further assess the effect of income tax changes on dividend policy, we examine the dynamic adjustment pattern of aggregate dividends. We first estimate the Marsh and Merton model in equation (9). The coefficients in equation (9) are estimated recursively forward and backward separately. Following this, the CUSUM and CUSUM-square tests are applied. Table 3 reports the results of Marsh and Merton’s dynamic dividend model. The tests for the S&P 500 index identify shifts in 1974, 1978 and 1981, respectively. On the other hand, the tests for the S&P 400 Index identify only shifts in 1977 and 1981. Consistent with the findings for the D/P and D/E ratios, the results of the dynamic dividend model indicate that there are structural shifts around 1977, 1978 and 1981. However, no major shifts are identified around 1986. We also estimate Lintner’s partial adjustment dividend model. The Lintner model involves fewer parameters and therefore, is less sensitive to the sample size of the recursive estimation. Table 4 reports the results of the partial adjustment model where the desired dividend is related to the stock price (Pt). The CUSUM and CUSUM-square tests based on the 500 index indicate that there are structural shifts in 197 1, 1976, 1988 and 1989. These results are generally consistent with the findings in Tables 1 and 2. Thus, there appear to be structural shifts after the 1986 tax reform. For comparison, we further estimate the Lintner model using reported earnings as a proxy of permanent earnings. Table 5 reports the results of the partial adjustment model of dividends using reported earnings (Et) as an explanatory variable. Again, the results indicate structural shifts in 1988 and 1989. In summary, the results for the structural shifts of dynamic dividend models are mixed. The result of the Lintner model indicates that the aggregate dividend payout ratio shifts (increases) after 1986, whereas the result of the Marsh and Merton model does not show such a shift. Notwithstanding this discrepancy, the structural shifts identified from the Lintner model appear to be consistent with those identified from the time series of D/E
CHUNCHI
302 Table 4.
Structural Shifts in Dynamic Dividend Q-D,_, =3L(y*P,-D,_t)+u,
Data
Tests
S&P 500 Index Quarterly Data (1965:1L1991:4)
S&P 400 Index Quarterly Data (1965:1L1991:4)
Table 5.
Data (1965:1-1991:4)
S&P 400 Index Quarterly Data (1965:1-1991:4)
Behavior
I
Years and Qtrs
Forward
1976: 1
Backward
1988:4
Forward
1971:4
Backward
1989:l
Forward
1977:3
Backward
1988:l
Forward
1971:2
Backward
1988: 1
CUSUM CUSUM SQUARE CUSUM CUSUM SQUARE
Structural Shifts in Dynamic Dividend Dt-Dt_l =h(yEt-Dt_l)+ut
Behavior
Years and Qtrs
Tests
Data S&P 500 Index Quarterly
WU
Forward
1983:l
CUSUM Backward
1988:4
CUSUM
Forward
1972: 1
SQUARE
Backward
1989: 1
Forward
1979:l
Backward
1988:3
CUSUM
Forward
1972:4
SQUARE
Backward
1989: 1
CUSUM
ratios. Both results provide some evidence of changes in the aggregate dividend behavior after 1986.
V.
SUMMARY
This paper examines the effect of differential capital gains and income taxes on corporate dividend policy. The paper analyzes the temporal pattern of dividend payout and the dynamic behavior of dividends for the S&P firms. The analysis of temporal dividend payout shows that structural shifts in the corporate dividend payout often occur around those years when there are significant changes in the tax code. In particular, the results from the analysis of the temporal payout pattern show an increase in the dividend payout ratio after the 1986 tax reform. In addition, the Brown-Durbin-Evans test results for the Lintner model show significant structural shifts after 1986. The overall results thus provide a modest support for the hypothesis that the 1986 tax reform has a positive effect on the aggregate dividend payout.
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APPENDIX The procedure of the CUSUM tests is as follows. For the CUSUM test, we first compute the recursive residuals and the CUSUM statistics:
Zr--+,_, WI
(A.1)
=
(1 +
gcx;_ ,x,_J’q wj
(A.2)
where r = k + 1, 3, . ... n, k is the number of independent variables in the regression, s is the sample standard deviation. Following this, we calculate cv = a(n - k)“* + 2a(r - k) (n - k)1’2 where a = .948 at the five percent significance level. If IW,.l> cv, we identify r as the switching point. For the CUSUM-square test, we first compute the test statistics:
(A.3)
Following
this, we compute CS, = MaxlS,. - (r - k)/(n - k)l
(A-4)
and compare CS, with the critical value (c) at the five percent significance level. For instance, if rr = 108, and k = 2 then the degree of freedom is l/2 (n - k) - 1 = 52 and the critical value c = .173 16. If ICS,I > c, then r is identified as the switching point.
ACKNOWLEDGMENTS The author acknowledges the research support by the George E. Bennett Center for Tax Research, Syracuse University. An earlier version of this paper was presented at the 1993 FMA meetings. The author is grateful to an anonymous referee and especially to the editor, Carl Chen for very helpful comments.
NOTES 1. Bolster and Janjigian (1991) find no evidence that dividend payouts increased in response to the 1986 tax reform. On the other hand, Papaioannou and Savarese (1994) find that dividend payout ratio increases for the low and medium payout-ratio firm groups after the tax reform. They argue that the lowering of the ordinary income tax rates and the elim-
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ination of the preferential tax treatment of capital gains were associated with increases in corporate dividend payout ratios. 2. We implicitly assume that the firm’s net operating income is identical to its economic income. In reality, this may not be true due to biases in accounting procedures. For instance, fixed asset values may decline due to new technological development. The decline in asset values would be capitalized and reflected in stock price, yet the firm’s net operating income would be unaffected. This problem could introduce noise into the stock price and earnings processes. We thank an anonymous referee for pointing out this potential problem. 3. Equation (9) was derived under the assumptions that dividends are driven by changes in firms’ permanent earnings and that the permanent earnings are proportional to the stock price (intrinsic value of the firm). For the derivation of equation (9), see Marsh and Merton (1987). 4. The value of h in equation (9) should be between zero and one. The h coefficient captures the stylized fact of the short-run dividend dynamics that managers change dividends away from the anticipated path in response to an unanticipated change in permanent earnings. The value of y should be positive. It measures the long-run average speed of convergence of the payout ratio to its steady-state target. The y coefficient captures Lintner’s stylized fact that firms typically set a long-run target for the dividend payout and move current dividends toward that target. 5. An examination of the historical data shows that the aggregate dividend payout ratio fluctuates over time and appears to be affected by business cycle. However, dividend payout increases substantially from 38% to 67% for the S&P portfolio between 1986 and 1989 during which there is no recession. Furthermore, although stock market crashes may affect the value of dividend yield, the shift in the dividend yield occurs before the 1987 crash. Thus, it is unlikely that the 1987 stock market crash is the cause of the shift in dividend yield in 1986. 6. Dividend payout or dividend yield movements may be affected by the movements of GNP, inflation and even lagged variables (Dimson, 1979). These complicated issues can be better treated in a separate study.
REFERENCES Beaver, W. H., Lambert, R. A., & Ryan, S.G. (1987). The information content of security prices: A second look. Journal of Accounting and Economics, 9, 139-157. Bolster, P., & Janjigian, V. (1991). Dividend policy and valuation effects of the Tax Reform Act of 1986. National Tax Journal, 44,5 1 l-5 18. Brennan, M. (1970). Taxes, market valuation and corporate financial policy. National Tax Journal, 23,417427. Brown, R. L., Durbin, J., & Evans, J. M. (1975). Techniques for testing the constancy of regression relationships over time. Journal of the Royal Statistical Society, B37, 149-192. Brittain, J. A. (1966). Corporate dividend policy. The Brookings Institution, Washington, DC.
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Chaplinsky, S., & Seyhun, H. N. (1990). Dividends and taxes: Evidence on tax-reduction strategies. Journal of Business, 63, 239-260. Dimson, E. (1979). Risk measurement when shares are subject to infrequent trading. Journal of Financial Economics, 7, 197-226. Fama, E., & Babiak, H. (1968). Dividend policy: An empirical analysis. Journul of the American Statistical Association, 63, 1132-l 161. Farrar, D., & Selwyn, L. (1967). Taxes, corporate financial policy and return to investors. National Tax Journal, 17,444-454. Kao, C., & Wu, C. (1994a). Tests of dividend signaling using the Marsh-Merton model: a generalized friction approach. Journal of Business, 67,45-68. Kao, C., & Wu, C. (1994b). Rational expectations, information signaling and dividend adjustment to permanent earnings. Review of Economics and Statistics, 76,49&502. Lee, C. F., Wu, C., & Djarraya, M. (1987). A further empirical investigation of the dividend adjustment process. Journal of Econometrics, .58,267-285. Lintner, J. (1956). Distribution of income of corporations. American Economic Review, 46, 97-l 13. Marsh, T. A., & Merton, R. C. (1987). Dividend behavior for the aggregate stock market. Journal of Business, 60, l-40. Masulis, R. W., & Trueman, B. (1988). Corporate investment and dividend decisions under differential personal taxation. Journal of Financial and Quantitative Analysis, 23, 369-386. Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. Journal of Business, 34,411433. Miller. M. H., & Scholes, M.S. (1978). Dividends and taxes. Journal of Financial Economics, 6, 333-364. Miller, M. H., & Scholes, M.S. (1982). Dividends and taxes: Some empirical evidence. Journal of Political Economy, 6, 1118-l 14 1. Papaioannou, G. J., & Savarese, C. M. (1994). Corporate dividend policy response to the Tax Reform Act of 1986. Financial Management, 23,56-63. Peterson, P. P., Peterson, D. R., & Ang, J. S. (1985). Direct evidence on the marginal rate of taxation on dividend income. Journal of Financial Economics, 14, 267-282.
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ABSTRACT This paper examines the effect of differential personal taxation on corporate dividend policy. The temporal pattern of corporate dividend payout and dynamic dividend behavior are examined over a period with significant changes in the tax code. The paper finds that there are structural shifts in the aggregate dividend payout and these shifts often coincide with tax law changes. The empirical results provide a modest support for the hypothesis that the elimination of the preferential capital gains tax treatment in 1986 has a positive impact on the aggregate corporate dividend payout ratio.
I.
INTRODUCTION
Financial theory has suggested that taxes affect corporate dividend policy (Farrar & Selwyn, 1969; Brennan, 1970; Masulis & Trueman, 1988). If this theory is correct, we should observe changes in corporate dividend payout whenever the government changes its income tax policy. However, Miller and Scholes (1978, 1982) have shown that dividend income could, to a large extent, be sheltered from taxation. Therefore, the effect of taxes on corporate dividend policy depends on the extent to which individuals can elude taxes. If individuals and institutions can successfully reduce the tax burden, the effect of taxes on corporate dividend policy would be minimal. Previous studies (Peterson, Peterson, & Ang, 198.5; Chaplinsky & Seyhun, 1990) have shown that individuals can reduce some but not all tax liability. Recently, Bolster and Janjigian (1991) and Papaioannou and Savarese (1994) examine the effect of the 1986 tax reform on corporate dividend policy and report Direct
all correspondence
to:
Chunchi
Wu, School
of Management,
Syracuse
University,
Syracuse,
NY
13244. International Review of Economics ISSN: 1059-0560
and Finance, S(3): 291-305 Copyright 0 1996 by JAI Press Inc. All rights of reproduction in any form reserved.
291
292
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conflicting results.’ The controversial evidence for the impact of taxes on corporate dividend policy suggest the need for a further examination of this issue. In this paper, we analyze the temporal pattern of aggregate dividend behavior to shed more light on the effect of taxes on dividend policy. The purpose of this paper is to examine the effect of changes in capital gains and income taxes on corporate dividend policy. We measure the extent of the tax effect on dividend policy from two different aspects. First, we analyze the intertemporal pattern of dividends to see whether dividend payout ratios are sensitive to changes in income taxes. In this analysis, we attempt to detect whether there is a significant shift in corporate dividend payout surrounding the years with changes in the income tax code. Second, we examine time variations of the parameters of the dynamic dividend models to detect whether there are structural shifts in corporate dividend behavior as a result of changes in taxes. The tax factor may affect the firm’s target dividend payout ratio and the dynamic adjustment pattern of dividends. If so, the parameters and the structure of the dynamic dividend models may change. An examination of the parameter and the structure of dividend models provides some clues to the effect of taxes on dividend policy. Our analysis focuses on the aggregate dividend behavior. The aggregate analysis allows us to assess the overall impact of taxation on dividends while bypassing the complicated issue of information signalling. The present study focuses on the impacts of tax reforms on the temporal pattern of corporate dividend payout and dynamic dividend behavior. This approach contrasts previous studies on dividends and taxes that emphasize individuals’ tax reduction strategies (Miller & Scholes, 1978; Chaplinsky and Seyhun, 1990). Our analysis shed more light on the role of taxes in the determination of corporate income distribution and dynamic dividend adjustment. Furthermore, we study the effects of tax reforms in recent years which were not covered by previous studies. The remainder of this paper is organized as follows. Section 2 discusses the relationship between taxes and dividend policy. Section 3 describes the empirical methodology while Section 4 discusses data and empirical results. Finally, Section 5 summarizes the findings.
II.
DIVIDENDS
AND TAXES
Miller and Modigliani (1961) argue that dividend policy is irrelevant for the cost of capital and the value of the firm in a world without taxes or transaction costs. They show that when investors can create any income pattern by selling and buying shares, the expected return required to induce them to hold firm shares will be invariant to the way the firm packages dividend payments and new issues of stocks. Since the firm’s assets, investment opportunities, expected future net cash flows and cost of capital are not affected by the choice of dividend policy, its market value is unaffected by any change in the firm’s payout pattern. Thus, dividend policy is irrelevant and firms can choose any payout pattern without affecting their value. Miller and Modigliani’s (MM) theory implies that dividend payout will fluctuate as a by-product of the firm’s investment and financing decisions, and therefore, will not exhibit a systematic pattern over time. MM’s irrelevance argument also applies to the case with corporate taxes but without personal taxes. It can be shown that the value of firms with or without debts is not affected by
293
Taxes and Dividend Policy
dividend policy if there are no transaction costs and investment decisions are independent of dividend decisions. The situation becomes more complicated when personal taxes are considered. In general, dividend policy becomes relevant if investors’ dividend income tax rates are higher than their capital gains tax rates. However, Federal tax laws are complex and individuals can shelter their income through tax-exempt and tax-deferred investments. Also, reducing the tax liability of dividend income often involves transaction costs. The existence of transaction costs may preclude individuals from fully using tax-reduction strategies. Despite these complications, dividends generally subject individual investors to a higher income tax rate than capital gains do. Thus, dividend policy may affect investors’ after-tax income and therefore, the cost of capital and the value of the firm. As Brennan (1970) indicates, for a given risk level, investors require a higher total return on a security, the higher its prospective dividend yield is, if a higher tax rate is levied on dividends than on capital gains. Therefore, from the standpoint of maximizing individuals’ net after-tax income, firms should pay the lowest cash dividends to reduce shareholders’ tax burden. If taxes are relevant to the firm’s value and cost of capital, we should observe a change in corporate dividend policy whenever there is a change in personal income and/or capital gains taxes. Firms and investors are expected to respond to the change in the tax code in making their dividend and investment decisions. For instance, when there is a decrease in the capital gains tax rate relative to the regular income tax rate, firms should reduce their dividend payout, and vice versa. The tax laws in the U.S. have gone through a couple of changes since 1980. In 1981, we had the largest tax cuts in the history of the United States. Top individual tax rates decreased from 70 to 50 percent and allowable contributions to Keoghs and other retirement systems were increased. The Tax Reform Act of 1984 lowered the holding period on capital gains from more than one year to more than six months, while the minimum holding period for the 85% exclusion for corporate investors was extended from 16 to 46 days. In 1986, the most sweeping revision of the tax code in the U.S. history took place. One of the most significant changes in 1986 is the elimination of the preferential tax treatment of long-term capital gains. An important question is whether these changes in tax laws have affected corporate dividend policy. To examine the effects of changes in tax laws on corporate dividend policy, we first analyze shareholders’ after-tax income under differential taxes. We assume that there are corporate and personal debts and the tax rates for capital gains and dividends are different. Also, for simplicity, assume that the firm’s net after-tax income is positive and the borrowing rate is equal for the firm and the shareholder.2 If the firm pays out all its cash flows as dividends, the shareholder will receive the following after-tax income $: Yd =
[(Y- iD,)( 1 - tJ - iD,](l - t&J
(1)
where Yd = the shareholder’s after-tax income dividends Y = the firm’s net operating income
if corporate
income
is distributed
totally
as
294
i= tc = tp = D, = Dp =
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the borrowing rate the corporate income tax rate the personal income tax rate corporate debt, and personal debt.
Alternatively, if the firm pays no dividends the shareholder’s after-tax income is F = (Y- iD,)(l
to let the shareholder realize capital gains, then
- t,)(l - tg) - iD,,(l - tp)
(2)
where k’s = the shareholder’s tg = the shareholder’s
after-tax income if the firm does not pay dividends capital gains tax rate.
The shareholder’s after-tax income is greater when the firm pays no dividends, that is, PTplyd> 1 if the capital gains tax rate is lower than the regular income tax rate. Two types of changes in personal taxes can affect the shareholder’s after-tax income. First, an increase in the capital gains tax rate, relative to the regular income tax rate, reduces the ratio YRlyd. In the special case where the capital gains tax rate is equal to the regular income tax rate, the ratio becomes one. Second, an across-the-board increase in personal income tax rates, if the capital gains rate is a percentage (p) of the regular income tax rate, raises the ratio Pl@. It can be shown that
a( YVf> at,
(1 -P)W-iD,)(l-$)I = [(Y-iD,)(1-tc,-iDpl(l-$)2
>.
(3)
The effect of tp on Plyd is positive because any increase in the regular income tax rate widens the difference between the capital gains and the regular income taxes. Conversely, a decrease in the income tax rate (as in 1981) will narrow the gap between the capital gains and regular income taxes. A change in the capital gains tax rate relative to the regular income tax rate should affect corporate dividend payout if the tax theory of dividends is correct. To that extent, we should observe changes in aggregate payout ratios around the tax reform years. The past decade provides an excellent opportunity for tracking the temporal effect of taxes on dividend policy because several unprecedented tax reforms were introduced in this period. In the following, we discuss the empirical methodology.
III.
EMPIRICAL
METHODOLOGY
To assess the effect of changes in taxes, we analyze the dividend payout pattern over a period with major tax reforms. In addition, we examine firms dynamic dividend behavior and see how they respond to tax law changes.
Taxes and Dividend
295
Policy
A.
/ntertempora/
Dividend
Payout
A direct analysis of the tax effect is to examine the intertemporal pattern of dividend payout to see whether there are significant changes in payout ratios around the years with income tax changes. Two measures of dividend payout are used in this analysis. The first payout measure is dividends divided by earnings (D/E). This is the type of payout ratio usually defined in the traditional financial analysis. The second payout measure is dividends divided by stock price (D/P). In this alternative measure, we assume that stock price is equal to the intrinsic value of the firm or the present value of expected future cash flows available to existing stockholders. Finance literature has suggested that stock price contains information about the firm’s permanent earnings (Marsh & Merton, 1987; Beaver, Lambert, & Ryan, 1987). Assuming that the required rate of return (a) for the firm is constant, the firm’s permanent earnings can be set equal to aP, the perceived returns on the intrinsic value of the firm. Thus, the D/P ratio is theoretically equal to l/a times the longterm payout ratio (dividends divided by permanent earnings). Changes in D/P therefore provide valuable information for changes in corporate payout policy. To analyze the intertemporal behavior of corporate dividends, we propose the following linear regression model:
z, = m
+ I_+
(4)
where Z, = the dividend payout measure (D/E or D/P) m = the mean of Z, and -ot - N(0, o*) is the disturbance term. We then apply the tests of structural changes proposed by Brown, Durbin and Evans (1975) to the above linear model. Brown, Durbin and Evans (1975) show that the residuals from recursive regressions contain useful information for detecting structural changes over time. They suggest CUSUM and CUSUM-square tests for detecting such changes. Let X = (xt, x2, . ... x,)‘, where xP j = 1, 2, 3 ,..., IZare the observation of the independent variables (including the intercept term) at time j and n equals the number of observations. The orders of X and Xj are nxk and krl, respectively, where k is the number of explanatory variables in the regression, which is equal to one in the present case. Then, the recursive residual of the regression model based on the first r observations is
w, =
Zr-xr’mr-
1
(5) (1 +xr’(XJ_J1x,)
where r = 2, 3, . ... n and wt - N(0, o*). The CUSUM and CUSUM-square defined as
w, = f
i j=k+l
wj
test statistics are
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(7)
where s is the sample estimate of the standard deviation (T. A series of these parameter estimates can be generated by a recursive estimation procedure. We initially estimate the model using the first k + 1 observations, and then expand the sample to include the next observation. This procedure is repeated until all the observations in the sample are exhausted. If taxes are indeed an important determinant of corporate dividend policy, we should observe a significant structural shift around the time of a major tax reform. To detect such a structural shift, we construct the CUSUM and CUSUM-square test statistics. Under the null hypothesis, the means of these two statistics are 0 and (I - k)l(n - k), where r= k+ 1, .... n, is the number of data points included in the estimation and II is the total observations in the sample. Brown, Durbin and Evans (1975) provide cutoff values for different statistical confidence levels. Details about the test procedure are described in the Appendix.
B.
Dynamic
Dividend
Adjustment
Previous studies (Lintner, 1956; Fama & Babiak, 1968; Brittain, 1966; Marsh & Merton, 1987; Lee, Wu & Djarraya, 1987; Kao & Wu, 1994a, 1994b) have suggested that corporate dividend behavior follows a dynamic adjustment process. If taxes are relevant, changes in the tax law will affect the firm’s (desired) target payout ratio and possibly the dividend adjustment pattern also. Either of these two effects can cause a shift in the structure of the dividend adjustment model. Therefore, an alternative way for examining the tax effects is to detect whether there is a significant change in the dynamic dividend behavior surrounding the time with changes in the tax code. We consider two dividend models. The first is Lintner’s partial adjustment model:
D,-D,-
1 =
h(D;-D,_,)+u,
(8)
where 0; is the desired dividend level, his the speed-of-adjustment coefficient and uI is the disturbance term. The desired dividend is traditionally related to reported earnings Et. For instance, Lintner set the desired dividend to yEl where y is the long-term payout ratio. However, reported earnings may not represent the true long-term permanent earnings of the firm. To remedy this problem, we also use stock price as a proxy for permanent earnings and set the desired dividend to y*P, where ‘y*equals ay, and a is the required rate of returns. The second dividend model is suggested by Marsh and Merton ( 1987):3
log(D,+ ,/D,) =
a0 +
~logWt + D,)/P,_ 1l -Glog(D,/P,_ ,I = q+
1
(9)
where a0 = the constant term h = the speed-of-adjustment parameter 6 = the coefficient of error-correction that drags short-run dividends toward the longrun payout ratio
Taxes and Dividend Policy
297
D, = the firm’s dividend at time t P, = the firm’s stock price at time t, and Et + 1 = the disturbance term at time t + 1. The Marsh-Merton model imposes a long-run steady-state condition for the target dividend payout on the short-run dividend dynamics.4 A series of parameter estimates for the dividend models can be generated by the CUSUM recursive procedure. Similar to the analysis of intertemporal dividend payout, the CUSUM and CUSUM-square tests of the structural changes can be applied. The test statistics will provide an indication whether there is a significant structural change in the corporate dividend behavior when the tax law changes.
IV.
DATA AND EMPIRICAL
RESULTS
Aggregate quarterly dividends, prices and earnings data were collected from the COMPUSTAT PDE tape. The COMPUSTAT tape contains quarterly dividends, prices and earnings for major market indexes. We select S&P 500 and 400 indexes for our study. The S&P 500 composite index includes utilities which are regulated firms adopting somewhat different dividend policy. The composition of the S&P 500 index is usually less consistent than that of the 400 index. We choose both indexes for comparison because the temporal behavior of these two indexes may be different. Major changes in the tax code are reported by Internal Revenue Service Statistics of Income. The IRS reports allow us to identify the years of significant changes in income and capital gains taxes. The study period covers 1965-91. The selection of a longer sample period increases the degree of freedom and reduces the sensitivity of parameter estimates to the sample size. Among the major tax law changes since 1965, we are particularly interested in the impact of the 1986 tax reform. Table 1 reports the results of CUSUM and CUSUM-square tests for dividend yields (D/P). The tests are performed recursively forward and recursively backward based on equation (4). The tests indicate that there are four shifts in the D/P ratio for the period 1965-91. These shifts occur in the years of 1970, 1978, 1982, and 1986. There were major changes in the tax code for capital gains and income taxes in 1978 and 1986. The Revenue Act of 1978 reduced corporate income taxes and changed tax shelter rules. The 1986 Tax Reform Act eliminated the preferential tax rate for capital gains. The rise in the capital gains tax rate after 1986 increases the relative value of dividends to investors. As a result, firms may have an incentive to distribute more income as dividends. The results of recursive estimation show that there is a significant increase in the D/P ratio in the late 1986 and early 1987. Thus, there appears to be a correlation between corporate dividend payout and income tax changes. Table 2 reports the results for the D/E ratio. The CUSUM and CUSUM-square tests identify five major shifts. These shifts occur in 1971, 1976, 1977, 1988, and 1989. The shift in 1971 might be due to external shocks associated with oil crisis and price freeze. In 1977, the Tax Reduction and Simplification Act was introduced. The shifts in 1988 and 1989 could be associated with the 1986 tax law change. Although the Tax Reform Act was introduced in 1986, the year of 1987 is a transitional period. The full implementation of the tax reform took place in 1988. Therefore, the significant shifts (increases) in the D/E
298
CHUNCHI Table 1.
Structural Shifts in Temporal Dividend-Price (D/P), = 171 + 2),
S&P 500 Index Quarterly
CUSUM
D/P (1965:1-1991:4)
CUSUM SQUARE
S&P 400 Index Quarterly
Years and Qtrs
Forward _ Backward
1978: 1 1982:2
Forward
1970:3
Backward
1986:3
Forward
1978:4
Backward
1982:2
Forward
1970:3
Backward
1986:3
CUSUM
D/P (1965:lL1991:4)
Table 2.
Ratios
Tests
Data
WU
CUSUM SQUARE
Structural Shifts in Temporal Dividend-Earnings
Ratios
(D/E), = m + 2),
S&P 500 Index Quarterly DiE (1965:lL1991:4)
S&P 400 Index Quarterly D/E (1965:1-1991:4)
Yam
Tests
D&2
and Qtrs
Forward
1977: 1
Backward
1989:2
CUSUM CUSUM SQUARE
Forward
1971:l
Backward
1988:3
Forward
1976:2
Backward
19x9:3
Forward
1971:2
CUSUM
/
I
CUSUM SQUARE I
Backward
I
1988:3
ratio for the years 1988 and 1989 may be due to the 1986 tax law change. These increases in the D/E ratio are consistent with the tax theory of dividends which predicts an increase in dividend payout as the capital gains tax rate rises. The increases in the D/E ratio is much stronger than the increases in the D/P ratio after 1986. It is possible that increases in the D/ E ratio after 1986 are affected by short-term fluctuations in the reported earnings figures. To smooth out the effect of short-term cyclical earnings fluctuations, we also performed the tests using three-years moving averages of earnings figures. It is interesting to note that the results based on the smoothed data exhibit a similar pattern as in Table 2. Figures la and 1b present the plots of temporal D/E ratios estimated recursively forward and backward for S&P 400 and S&P 500 indexes. The D/E ratios for both 500 and 400 indexes are quite stable for most of the study period. The results show a significant upward shift in the D/E ratio after 1987, which is confirmed by both the CUSUM and CUSUMsquare tests. The results of the CUSUM estimation refect the pattern of the underlying temporal D/E series. The historical dividend payout ratios for the S&P 500 (S&P 400) index increase from about 38% (39%) in 1986 to 67% (69%) in 1989. During this period, the CUSUM backward estimates of dividend payout ratios for the S&P 500 (S&P 400) index increase from 55% (50%) to 60% (56%).
Taxes
and
Dividend
299
Policy
Figure la.
Plot of CUSUM Estimates of S&P 500 D/E Ratios
0.75 I
P
0.7 0.65 0.6 0.55 0.5 0.45
Figure I b.
Plot of CUSUM Estimates of S&P 400 D/E Ratios
0.75 0.7
I
t
0.65 0.6 0.55 0.5 0.45
Figure 1.
Plot of CUSUM Estimates of Dividends
Payout Ratios (1965:1-1991:4)
Figures 2a and 2b show the plots of temporal D/P ratios estimated recursively forward and backward for the 500 and 400 indexes. The results for both indexes exhibit a similar pattern. The backward estimations indicate a short-term upward shift of the dividend payout in late 1986. This upward shift is also confirmed by both the CUSUM and CUSUMsquare tests. The CUSUM estimates of dividend yields for the S&P 500 (400) index increase from 0.0081 (0.0071) in 1986 to 0.0086 (0.0077) in 1988. It is also worth noting that historical dividend yields exhibit variations. The mean dividend yield of the S&P 500 index is around 0.008 before 1973. The mean dividend yield increases to 0.013 between
300
CHUNCHI Figure 2a.
Plot of CUSUM Estimates of S&P 500 D/P Ratios
Figure 2a.
Plot of CUSUM Estimates of S&P 400 D/P Ratios
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0.011
0.0105 0.01 0.0095 0.009 0.0085 0.008 0.0075
Figure 2.
Plot of CUSUM Estimates of Dividends
Yields (1965: l-1 99 1:4)
1973 and 1982. It then drops to 0.009 after 1982. Dividend yields appear to be affected by other economic factors.5 Nevertheless, a short-term shift in dividend yields is identified by the CUSUM tests in 1986, which is associated with the 1986 tax refotm6 In summary, the results above suggest that there is an upward shift in the aggregate corporate dividend payout after the 1986 tax reform. This shift may be attributed to the elimination of the favorable capital gains tax treatment after 1986. Also, there is a slight difference between the timing of shifts for the D/P and D/E ratios. The shift in the D/P ratio occurs in 1986, while the shifts in the D/E ratio occur after 1987. This discrepancy may be
Taxes and Dividend
301
Policy
Tubk 3. log@, + IQ)
Structural
Shifts in Dynamic Dividend
= oo + hlog[(P, + D,)lP, - 11- ~log(q&
S&P 500 Index Quarterly Data (1965:1-1991:4)
S&P 400 Index Quarterly Data (1965:1-1991:4)
CUSUM CUSUM SQUARE
_~
- 1) + Et, 1 Yeur.s and Qrrs
Tests
D&t
Behavior
Forward ~____~ Backward
1978:4 -
Forward
1974:2
Backward
1981:4
Forward
-
CUSUM Backward CUSUM SQUARE
Forward
1977:2
Backward
1981:3
due to the fact that stock price reacts more quickly to changes in the tax law, whereas it takes longer time for companies to alter the dividend payout ratio. It may also possibly be related to the fact that the full scale effect of the 1986 tax reform took place in 1988 or later. Therefore, the time series of D/P and D/E might exhibit somewhat different patterns. To further assess the effect of income tax changes on dividend policy, we examine the dynamic adjustment pattern of aggregate dividends. We first estimate the Marsh and Merton model in equation (9). The coefficients in equation (9) are estimated recursively forward and backward separately. Following this, the CUSUM and CUSUM-square tests are applied. Table 3 reports the results of Marsh and Merton’s dynamic dividend model. The tests for the S&P 500 index identify shifts in 1974, 1978 and 1981, respectively. On the other hand, the tests for the S&P 400 Index identify only shifts in 1977 and 1981. Consistent with the findings for the D/P and D/E ratios, the results of the dynamic dividend model indicate that there are structural shifts around 1977, 1978 and 1981. However, no major shifts are identified around 1986. We also estimate Lintner’s partial adjustment dividend model. The Lintner model involves fewer parameters and therefore, is less sensitive to the sample size of the recursive estimation. Table 4 reports the results of the partial adjustment model where the desired dividend is related to the stock price (Pt). The CUSUM and CUSUM-square tests based on the 500 index indicate that there are structural shifts in 197 1, 1976, 1988 and 1989. These results are generally consistent with the findings in Tables 1 and 2. Thus, there appear to be structural shifts after the 1986 tax reform. For comparison, we further estimate the Lintner model using reported earnings as a proxy of permanent earnings. Table 5 reports the results of the partial adjustment model of dividends using reported earnings (Et) as an explanatory variable. Again, the results indicate structural shifts in 1988 and 1989. In summary, the results for the structural shifts of dynamic dividend models are mixed. The result of the Lintner model indicates that the aggregate dividend payout ratio shifts (increases) after 1986, whereas the result of the Marsh and Merton model does not show such a shift. Notwithstanding this discrepancy, the structural shifts identified from the Lintner model appear to be consistent with those identified from the time series of D/E
CHUNCHI
302 Table 4.
Structural Shifts in Dynamic Dividend Q-D,_, =3L(y*P,-D,_t)+u,
Data
Tests
S&P 500 Index Quarterly Data (1965:1L1991:4)
S&P 400 Index Quarterly Data (1965:1L1991:4)
Table 5.
Data (1965:1-1991:4)
S&P 400 Index Quarterly Data (1965:1-1991:4)
Behavior
I
Years and Qtrs
Forward
1976: 1
Backward
1988:4
Forward
1971:4
Backward
1989:l
Forward
1977:3
Backward
1988:l
Forward
1971:2
Backward
1988: 1
CUSUM CUSUM SQUARE CUSUM CUSUM SQUARE
Structural Shifts in Dynamic Dividend Dt-Dt_l =h(yEt-Dt_l)+ut
Behavior
Years and Qtrs
Tests
Data S&P 500 Index Quarterly
WU
Forward
1983:l
CUSUM Backward
1988:4
CUSUM
Forward
1972: 1
SQUARE
Backward
1989: 1
Forward
1979:l
Backward
1988:3
CUSUM
Forward
1972:4
SQUARE
Backward
1989: 1
CUSUM
ratios. Both results provide some evidence of changes in the aggregate dividend behavior after 1986.
V.
SUMMARY
This paper examines the effect of differential capital gains and income taxes on corporate dividend policy. The paper analyzes the temporal pattern of dividend payout and the dynamic behavior of dividends for the S&P firms. The analysis of temporal dividend payout shows that structural shifts in the corporate dividend payout often occur around those years when there are significant changes in the tax code. In particular, the results from the analysis of the temporal payout pattern show an increase in the dividend payout ratio after the 1986 tax reform. In addition, the Brown-Durbin-Evans test results for the Lintner model show significant structural shifts after 1986. The overall results thus provide a modest support for the hypothesis that the 1986 tax reform has a positive effect on the aggregate dividend payout.
Taxesand DividendPolicy
303
APPENDIX The procedure of the CUSUM tests is as follows. For the CUSUM test, we first compute the recursive residuals and the CUSUM statistics:
Zr--+,_, WI
(A.1)
=
(1 +
gcx;_ ,x,_J’q wj
(A.2)
where r = k + 1, 3, . ... n, k is the number of independent variables in the regression, s is the sample standard deviation. Following this, we calculate cv = a(n - k)“* + 2a(r - k) (n - k)1’2 where a = .948 at the five percent significance level. If IW,.l> cv, we identify r as the switching point. For the CUSUM-square test, we first compute the test statistics:
(A.3)
Following
this, we compute CS, = MaxlS,. - (r - k)/(n - k)l
(A-4)
and compare CS, with the critical value (c) at the five percent significance level. For instance, if rr = 108, and k = 2 then the degree of freedom is l/2 (n - k) - 1 = 52 and the critical value c = .173 16. If ICS,I > c, then r is identified as the switching point.
ACKNOWLEDGMENTS The author acknowledges the research support by the George E. Bennett Center for Tax Research, Syracuse University. An earlier version of this paper was presented at the 1993 FMA meetings. The author is grateful to an anonymous referee and especially to the editor, Carl Chen for very helpful comments.
NOTES 1. Bolster and Janjigian (1991) find no evidence that dividend payouts increased in response to the 1986 tax reform. On the other hand, Papaioannou and Savarese (1994) find that dividend payout ratio increases for the low and medium payout-ratio firm groups after the tax reform. They argue that the lowering of the ordinary income tax rates and the elim-
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ination of the preferential tax treatment of capital gains were associated with increases in corporate dividend payout ratios. 2. We implicitly assume that the firm’s net operating income is identical to its economic income. In reality, this may not be true due to biases in accounting procedures. For instance, fixed asset values may decline due to new technological development. The decline in asset values would be capitalized and reflected in stock price, yet the firm’s net operating income would be unaffected. This problem could introduce noise into the stock price and earnings processes. We thank an anonymous referee for pointing out this potential problem. 3. Equation (9) was derived under the assumptions that dividends are driven by changes in firms’ permanent earnings and that the permanent earnings are proportional to the stock price (intrinsic value of the firm). For the derivation of equation (9), see Marsh and Merton (1987). 4. The value of h in equation (9) should be between zero and one. The h coefficient captures the stylized fact of the short-run dividend dynamics that managers change dividends away from the anticipated path in response to an unanticipated change in permanent earnings. The value of y should be positive. It measures the long-run average speed of convergence of the payout ratio to its steady-state target. The y coefficient captures Lintner’s stylized fact that firms typically set a long-run target for the dividend payout and move current dividends toward that target. 5. An examination of the historical data shows that the aggregate dividend payout ratio fluctuates over time and appears to be affected by business cycle. However, dividend payout increases substantially from 38% to 67% for the S&P portfolio between 1986 and 1989 during which there is no recession. Furthermore, although stock market crashes may affect the value of dividend yield, the shift in the dividend yield occurs before the 1987 crash. Thus, it is unlikely that the 1987 stock market crash is the cause of the shift in dividend yield in 1986. 6. Dividend payout or dividend yield movements may be affected by the movements of GNP, inflation and even lagged variables (Dimson, 1979). These complicated issues can be better treated in a separate study.
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