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Taxes and dividends: The UK evidence
ELSEVIER
Journal of Banking & Finance 20 (1996) 455-472
Journalof BANKING & FINANCE
Taxes and dividends: The UK evidence M. Ameziane Lasfer * Centre for Empirical Research in Finance and Accounting, City Unwersity Business School, Barbican Centre, London, EC2Y 8HB, UK
Received 15 December 1993; accepted 15 January 1995
Abstract This paper provides empirical evidence on the simultaneous effects of both corporation and personal income taxes on dividend payment adjustments and on the behaviour of share prices on the ex-dividend dates. The results show that companies set their dividend policies to minimise their tax liability and to maximise the after-tax return of their shareholders. In particular, firms that are unable to deduct the advanced corporation tax from their tax liability are found to pay low dividends. In addition, consistent with the tax hypothesis, we find that the differential taxation of dividends and capital gains results in a decrease in ex-day share prices by significantly less than the amount of the dividend. There is no evidence of a tax-induced dividend clientele. JEL classification: G35 Keywords: Dividend policy; Ex-day price behaviour; Imputation tax system; Personal taxes
I. Introduction The tax implication of a particular d i v i d e n d policy is perhaps the principal challenge to the d i v i d e n d irrelevance proposition. Both corporate taxes and
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personal income taxes are expected to affect firm's dividend payout ratios, its subsequent share price movements and the composition of its shareholders. However, despite the theoretical impact of taxation on dividends, little or conflicting empirical evidence has been provided to date. For instance, in the dividend literature we find no tax analysis that can explain the cross-sectional or time-series variations in dividend payments made by individual companies. The empirical studies on the effect of taxes on returns do not all support the view that shares with greater tax exposure tend to sell at lower prices and have greater expected pre-tax rates of return. Furthermore, it is not clear whether the tax effects that motivate the model occur at a single point in time, such as the ex-day, or are spread over a longer time period, i Moreover, the Elton and Gruber (1970) hypothesis that the differential taxation of dividend and capital gains is reflected in the drop in the ex-day share prices is difficult to test because of possible simultaneous short-term trading effects (e.g. Kalay, 1982). None of the previous work considers the joint effects of corporate taxes and personal income taxes on dividend payments. The purpose of this paper is to contribute to the dividend literature by analysing the simultaneous effects of both corporate taxes and personal income taxes on the firm's dividend decision and its ex-day share price behavior. The UK environment provides an ideal framework for studying this issue as the imputation system alleviates part of the double taxation on dividend and provides a link between the tax treatment of dividend at firm and at individual shareholder levels. We model this link and show that, in the absence of a tax-induced dividend clientele, firm's dividend policy depends on corporate and personal taxes. Using panel data and an appropriate statistical methodology to account for cross-sectional and time-series differences in taxes and in other explanatory variables, we find that companies set their dividend policies to minimise their tax liability and to maximise the after-tax return of their shareholders. In particular, firms that are unable to deduct the advanced corporation tax from their tax liability are found to pay low dividends. Also, consistent with the proposition that taxes affect equilibrium share prices on the ex-dividend date, we find that ex-day share prices drop by less than the amount of the dividend and ex-day returns are positively and monotonically distributed across dividend yields, though no tax-induced dividend clientele is observed. The rest of the paper is organized as follows. In Section 2, we develop the hypotheses. In Section 3, we describe the data and the methodology. In Section 4, we present an analysis of the empirical results. Conclusions are set out in Section 5.
i See Miller (1986) and Keim (1988) for a review of these studies.
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2. Theoretical background and hypotheses tested 2.1. Taxes and corporate dividend payment The tax burden on dividends depends on both corporate and personal income tax systems. 2 In a classical system, the total tax is the sum of the corporation tax, the effective capital gains tax and the tax on dividends. Typically, the tax on dividends exceeds the gains tax creating an incentive to reduce dividends. In an imputation system, on the other hand, the total tax is given by the corporation tax plus the effective gains tax plus the reduced dividend tax. If the reduction in the tax on dividend is large enough to make reduced dividend tax lower than the effective capital gains tax, an incentive to increase dividends is created. Under the imputation system, a firm that distributes a net dividend in cash of, say, d must, in addition, pay the advanced corporation tax (ACT) equal to the basic rate of income tax on the gross dividend. If s is the standard rate of income tax, the gross dividend, D, is defined as d / ( 1 - s ) and A C T is sD, i.e., s d / ( 1 - s). The A C T is first paid to the tax authorities fourteen days after the end of the quarter in which the dividend is paid and then deducted from the firm's corporation tax liability which is usually payable nine months after the end of the accounting period. Shareholders pay tax mD, where m is their personal rate of income tax and receive a tax credit of sD. Thus, shareholders' dividend tax is ( m - s)D, i.e., d ( m - s ) / ( 1 - s). For investors taxed at m < s dividend is not taxed or tax subsidized. Only individuals taxed at m > s pay a dividend tax. For example, if the cash dividend, d, is £7.00 and s = 30%, the tax credit is £3.00. Tax-exempt institutions claim the full tax credit and their after-tax dividend is £10.00. Investors taxed at the basic income tax rate have no additional dividend tax to pay. Individuals with tax rate m of, say, 40% are only subject to an additional income tax demand of £1.00 and their after-tax dividend is £6.00. In this case, the effective dividend tax is 14.3% ( ( 4 0 % - 3 0 % ) / ( 1 - 3 0 % ) ) . Cash dividends received by corporate investors from other U K companies are not taxed again as a profit. The associated tax credit cannot be refunded by the tax authorities but corporate investors can use it to frank their own dividend payments or offset it against their previous tax liability. Assuming an effective corporation tax rate of r c, the dividend tax burden is. therefore, the sum of corporate tax paid, r~d/(1 - re), and the individual taxes paid, d(m - s ) / ( 1 - s), as a percentage of the pre-corporate-tax dividend, d / ( l re): ~d d(m-s) - - + 1 -% 1-s (1- re)(1-m) =1(1) d 1-s 1-r c On the other hand, if earnings are retained and reinvested at the cost of capital,
2 Detailed analysis of dividend tax systems are in King (1977). Poterba and Summers (1985).
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they would generate an after-tax capital gains of r(1 - z ) where r is the firm's after-tax earnings that are retained and z is the effective capital gains tax rate. The capital gains tax burden is the sum of the corporate tax paid, % r/(1 - %), and the individual tax rz, all divided by the precorporate-tax capital gains, r'r~
--+rz
1--~-c r
= 1 - (1 - ~'c)(1 - z )
(2)
1-% The overall tax burden on dividend and retained earnings borne by the firm and its shareholders can be derived as the weighted average of the dividends and capital gains tax burdens as a proportion of the firm's payout ratio and can be defined as: d[ --
(1 - re)(1 - m) ] 1-
=1-(1-~-c)
( +
~
]2 s
d) 1-
[1-(m-rc)(1-z)]
(l-z)
+(l-z)
(3)
where d/E is the firm's payout ratio and E are earnings. Eq. (3) implies that the overall tax burden on dividends and capital gains is a function of the corporation tax, the dividend payout ratio and the differential taxation of dividends and capital gains. Let TD = (1 - m)/[(1 - s)(1 - z)] represent this tax discrimination variable (King, 1977) and rearranging, Eq. (3) becomes:
1 - ( 1 - "Cc)(1- z){ d [ T D - 1 ] + l}
(4)
Thus, when dividend tax is equal to the tax on capital gains, TD is unity and the overall tax burden is invariant with respect to t~e payout ratio. However, when TD is higher (lower) than one, the overall tax burden decreases (increases) as the payout ratio increases. TD varies with the income tax rate of individual investor. For example, tax-exempt investors (m = z = 0), given a corporation tax rate of 52% and a standard rate of income tax of 30%, will have a tax discrimination factor of 1.43 and a tax burden on dividends of 31.4% compared to a 52% tax burden if earnings are retained. For individuals taxed at m = s = 30% and at an effective capital gains tax of, say, 20%, TD is 1.25 and the dividend tax amounts to 52% while the capital gains tax burden rises to 61.6%. This implies that both tax-exempt investors and basic income taxpayers are expected to favour dividends. However, for investors taxed at a higher income tax rate, TD is less than one and their dividends bear higher tax than retained earnings. These investors will only
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favour dividends if the effective capital gains tax rate, z, is higher than the additional dividend tax, i.e., z > (m - s ) / ( 1 - s). In practice the imputation system is fully operational only when ACT is recovered, i.e., when dividends are not paid from profits generated abroad and taxable profits exceed gross dividends. In the 1970s and early 1980s other corporate tax allowances, such as capital allowances and stock relief, reduced significantly firms' present and future taxable profits to below their gross dividend payments. These allowances led companies to be tax exhausted where their corporation tax liability is nil or negative and their ACT is unrelieved (e.g. Devereux, 1987; Edwards et al., 1987). Unrelieved ACT can normally be set against the corporation tax payments of the two previous years or carried forward to offset against future corporation tax liabilities. However, if its recoverability is not reasonably certain and foreseeable in the future, A C T is directly written off in firms' accounts increasing the tax cost on dividends and resulting in a higher tax burden on dividends relative to the implied tax on retained earnings. For example, from Eq. (3), any dividend paid by tax exhausted firms for which, say, ~'c = 0, to tax-exempt investors (whose m = z = 0) carries a tax burden of s / ( 1 - s ) compared to the tax burden on capital gains of 0. The above tax arguments imply that, where dividend tax-clienteles do not prevail, as shown in Section 4.4 below, a firm is expected to set its dividend policy to minimize its tax liability and to maximize the after-tax return of its shareholders. 2.2. Taxes and ex-day share price behaviour Taxes are also expected to affect the equilibrium share price behaviour on the day when shares are first quoted ex-dividend (the ex-day). Elton and Gruber (1970) show that, when dividends are taxed at a higher rate than capital gains, ex-day share prices drop by less than the amount of the dividend and the drop-off ratio reflects the tax differential between dividends and capital gains. In the UK, although dividends carry a tax credit, they are effectively taxed at a higher rate than capital gains. Until 1984, investment income above a threshold was subject to a surcharge of 15%. This, for example, caused the dividend in 1979, when received by an investor paying the top rate of income tax of 83%, to be effectively taxed at 98% less the tax credit of 35%, i.e., 63% compared to the standard capital gains tax rate of 30%. Although, the higher rate of income tax was reduced in 1980 to 60% and the basic rate to 30%, the tax burden on dividend of 45% (60% + 15% - 30%) was still higher than even the standard capital gains tax of 30%. Given this tax differential, we expect ex-day share prices to decrease by less than the amount of dividend resulting in positive ex-day returns. Taxes are not, however, the sole determinants of ex-day returns. When ex-day returns are positive, investors whose dividend income and capital gains are taxed equally, are expected to buy securities before the ex-day and sell them after they go ex-dividend reducing ex-day returns to zero (e.g., Kalay, 1982). Elton et al.
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(1984) argue, however, that, in this case, the observed ex-day drop may only understate the size of the tax effect because the magnitude of the price decline will be capped by the transaction costs involved in short-term trading. In the UK, however, short-term trading is unlikely to occur because of institutional regulation and potential tax penalties 3. However, this legislation will only reduce, not eliminate, short-term trading (e.g., Menyah, 1993). If short-term traders do capture dividends, then we expect ex-day returns to be randomly distributed around zero but positive before the ex-day and negative thereafter.
3. Sample selection and methodology 3.1. Sample description
The initial sample of the firms provided by E X S T A T data base met three criteria. First, to ensure that dividends are paid from profits generated in the UK, firms are selected on condition that their main activities are concentrated in the U K domestic market. Second, companies must have a continuous daily price quotation on the London Stock Exchange and have their accounting data available for the full sample period in Exstat, Extel Cards and Datastream. Financial companies are excluded because of their special tax treatment. 4 Third, the ex-day and the announcement day must be separated by at least five calendar days so that the ex-day abnormal returns are not distorted by announcement effects. With the exception of these conditions, the selection of firms is random, covering a wide range of companies from various industries. The final sample consists of 108 industrial and commercial companies for the period 1973 to 1983, resulting in 1188 pooled observations. 5 The lack of data on daily share prices has restricted the sample period used in the analysis of returns to 1980-83, a total of 550 ex-day returns (246 interim and 304 final dividends). The effective corporate tax rates are calculated for each individual company using a computer based tax model that takes into account all allowances and reliefs that existed during the sample period as well as previous losses and ACT.
3 The anti-tax avoidance legislation prevents dealers, tax-exempt institutions and individuals from trading around the ex-day for the sole purpose of capturing dividends and/or avoiding taxes. See Poterba and Summers (1984, p. 1402) for details on the 1970Anti-Avoidance Act. 4 See Edwards and Mayer (1983) for bank taxation. 5 Our sample covers an average of 5% of the total number of firms in EXSTAT (15% of live companies during all the sample period) and 18% of the total market value. It includes small companies as well as the large domestic firms. The earliest data available in EXSTAT is 1972. The sample period is constrained by the 1984 UK Corporation Tax Reform where companies are able to elect a set of tax allowances for a transitory period of 3 years. In the post-1984 period, it was not possible to make generalized comparisons across companies.
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We define a dummy variable of one to represent those companies for which taxable profits are lower than gross dividends. These companies are considered to be tax exhausted and their A C T is assumed to be irrecoverable. The tax discrimination variable is computed as follows. The basic income tax rates are the rates that prevailed during the sample period. Shareholders are assumed to face the same effective capital gains tax rate. The statutory capital gains tax rate is computed from The Inland Revenue Statistics. Following King (1977), we use a value of 10% for the proportion of accrued gains realized in each year and compute the effective capital gains tax rates by discounting these statutory rates using the redemption yield on long dated government stocks. ~ The marginal income tax rate, m, is function of both the composition and the holdings of the different shareholders. To compute m we group shareholders into three main groups according to their tax treatment: tax-exempt institutions, insurance companies and individuals. The first group includes pension funds, pension business of insurance companies and charities. The second group, taxed at a special rate, includes funds such as life insurance policies invested by insurance companies for their clients. The third group includes direct household share ownership and indirect ownership through taxed intermediaries such as mutual funds and banks. From companies' reports and Extel cards, we obtain the proportion of shares held by individuals, financial institutions and corporate investors. We then classify these according to the above three categories so that the appropriate tax rates can be applied. The household group (including directors' interests both beneficial and non-beneficial 7) is assumed to be taxed at the higher rate of income tax. For the remaining proportion of shareholders not disclosed in companies' reports, we use the aggregate weighted average tax rates for each class of shareholders. To compute the aggregate weights, we use U K surveys on share ownership (CSO, 1989; Stock Exchange, 1982, 1991) and extrapolate the trend to cover our sample period. 8 The proportion of each g r o u p ' s holdings is added to the percentage disclosed in the firm's account to find the most likely holdings of this category for the firm in question. 9 For the household group, we compute the average income tax rates from The Inland Revenue Statistics where the distribution of share ownership is
6 Alternative annual turnover rates than the 10% did not change significantly our results. 7 When such non-beneficial holdings are, for instance, as joint trustec with one other person of a pension fund, this proportion is considered to be tax exempt. 8 These surveys find that, from 1969 to 1989, institutional holding rose from 9% to 30.4% household's share declined from 47.4% to 21.3%. See King et al. (1984) and King (1977) for a detailed description of the procedures used in deriving the respective tax rates. 9 For instance, if a firm reports that insurance companies hold 8%, individuals 12% and tax exempt institutions 10% and if, at the aggregate, insurance companies hold 20%, then the likely holding of the insurance group in this firm is 22% (8% + (100%- 8 % - 12%- 10%)× 20%).
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Table 1 Descriptive statistics on pooled time-series and cross-sectional means of the tax variables for a sample of 108 industrial and commercial companies over the period 1973-1983. Variables
Mean
Median
S.D.
Minimum
Maximum
Tc ~c TX m Zs z s TD
0.503 0.203 0.290 0.434 0.282 0.139 0.323 0.969
0.520 0.173 0.000 0.426 0.291 0.137 0.330 0.994
0.041 0.188 0.454 0.064 0.019 0.011 0.022 0.102
0.300 0.000 0.000 0.360 0.246 0.121 0.300 0.222
0.520 0.520 1.000 0.868 0.300 0.160 0.350 1.083
Notes: Tc is the standard corporation tax rate adjusted for small companies' rates; r c is the effective corporation tax rate computed for each company using a computer tax model taking into account all the allowances and reliefs as well as previous losses and the advanced corporation tax (ACT) a; TX is the tax exhaustion dummy variable equal to 1 if the taxable profit is lower than gross dividends and, thus, ACT is unrelieved; m is the marginal income tax on dividend computed using the various shareholders' tax categories and respective holdings in each firm; Zs is the standard capital gains tax rate computed as the ratio of capital gains payments over the amount of capital gains (data are from the Inland Revenue Statistics); z is the effective capital gains tax rate calculated by discounting the statutory rates using the redemption yield on long-dated government stocks b; s is the basic rate of income tax; TD is the tax discrimination variable equal to (1 - m)/[(1 - z)(1 - s)]; S.D. is the standard deviation. a If taxable profit, defined as profit before tax less allowances and reliefs, is not positive then losses are set off against previous two years' profit, or carried forward to subsequent year. A value of 10% is taken as the proportion of accrued capital gains realised in each year.
r e l a t e d to the total i n c o m e t a x e s p a i d b y e a c h s h a r e h o l d e r g r o u p ( O r h n i a l a n d Foldes, 1975; K i n g , 1977). T h e d e f i n i t i o n o f s h a r e o w n e r s h i p m a y s u f f e r f r o m the n o n - a l l o c a t i o n o f n o m i n e e h o l d i n g s , a c a s e w h e r e i n s t i t u t i o n s s u c h as b a n k s h o l d s h a r e s as i n t e r m e d i a r i e s . T o o v e r c o m e this p r o b l e m , the n o m i n e e s r e p o r t e d in c o m p a n i e s ' a c c o u n t s are a l l o c a t e d to the t h r e e s h a r e h o l d e r s ' c a t e g o r i e s u s i n g the a b o v e s u r v e y s ' f i n d i n g s . A l t h o u g h t h e s e s u r v e y s trace b a c k all n o m i n e e h o l d i n g s to t h e i r u l t i m a t e b e n e f i c i a l o w n e r , they are o n l y c a r r i e d o u t at 6 - y e a r i n t e r v a l s a n d w e rely o n the e x t r a p o l a tion o f t h e i r f i n d i n g s to c o v e r o u r s a m p l e period. T a b l e 1 r e p o r t s the d e s c r i p t i v e statistics o f the tax v a r i a b l e s u s e d in this study. T h e e f f e c t i v e c o r p o r a t i o n tax rates are s i g n i f i c a n t l y l o w e r t h a n the s t a n d a r d rates (the t-statistic o f the d i f f e r e n c e b e t w e e n the t w o m e a n s is - 5 3 . 6 ) . T h e tax e x h a u s t i o n d u m m y v a r i a b l e s h o w s that in 2 9 % o f the c a s e s A C T is i r r e c o v e r a b l e . T h e m e a n tax d i s c r i m i n a t i o n v a r i a b l e , TD, is 0.97. T h i s result i n d i c a t e s that, o n a v e r a g e , t h e r e is n o b i a s for d i v i d e n d s o v e r capital gains. H o w e v e r , the m a x i m u m v a l u e o f 1.08 a n d the m i n i m u m o f 0 . 2 2 s u g g e s t that t h e r e are c a s e s w h e r e t h e r e is a d i s t i n c t p r e f e r e n c e for e i t h e r d i v i d e n d s or capital gains.
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3.2. M e t h o d o l o g y
To investigate the impact of taxation on corporate dividend distribution behaviour, the Lintner (1956) specification is modified to incorporate both the tax exhaustion and the tax discrimination variables. The effects of these tax variables cannot be analyzed in the Lintner's parameters because tax exhaustion depends on taxable profit not reported earnings and tax discrimination variable is not constant through time. The original Lintner model suggests that firms determine their desired dividends in any period, D * , by relating a target pay-out ratio to current reported earnings. We assume that the target pay-out ratio is function of the firm's and shareholders' marginal tax rates, as represented in the following model:
(5)
0 7 = y E P S t + ~ T X t + 0 TD t + I.tt
where E P S t is the earnings per share at time t, T X t is the tax exhaustion dummy variable and T D is the tax discrimination variable. 10 /z is the error term with zero mean and constant variance. This equilibrium relationship indicates that a firm will not change its level of dividends unless one or more of the exogenous variables has changed. In any one year, a firm is assumed to adjust partially to the desired level of dividend payment and that the change in dividend per share from t - 1 to t, ( D t - Dr_ 1), is:
Dt-Dt-1
=/30 +
A(D,* - D r _ l )
+ at
(6)
The constant, /3o, is expected to be positive to reflect the reluctance of companies to reduce their dividend payments and their desire for a gradual growth in the level of dividends (Lintner, 1956). The speed of adjustment, A, is expected to reflect the degree of movement toward the new target. Combining Eqs. (5) and (6) we obtain:
Dt =/30 q- A y E P S t + (1
-
A ) D t _ 1 d- A O T D t + A 6 T X t + e t
(7)
Defining /31 = Ay; /32 = (1 - h); /33 = A0 and /34 = AS, the estimated equation is Dt =/30 + / 3 1 E P S , + / 3 2 D t - 1 +/33TDt +/34TXt + et
(8)
From the above analysis we expect /30 , /31, /32 and /33 to be positive and /34 negative.
10 TX measures the firm's corporation tax position while TD measures the personal income tax rate of its shareholders. These two tax variables are independent because firms pay ACT irrespective of their taxable profit and their shareholders are deemed to have received the cash dividend and the tax credit. The correlation between TX and TD is -0.016, not significant.
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4. Empirical results 4.1. Impact of taxation on firm's dividend adjustment Ordinary least-squares method cannot be used to estimate the above dividend equation because the method assumes that the coefficients are not affected by time or unit observation. For our panel data, this assumption is violated. Instead, we use the generalized least squares method (e.g. Greene, 1993; Judge et al., 1985) and obtain the following results:
Dit = - 0.011 + O.034EPSit + 0.831Dit_ 1 + O.015TDit - O.O02TXit (-2.29) ,~2 = 0.862
(18.9)
(66.2)
F-statistic = 2.336
(3.27)
(-2.62)
(9)
L - M = 71.33 H = 175.38
(t-statistics in parentheses) where L - M is the Lagrange Multiplier and H is the Hausman test. it Eq. (9) shows that the coefficients of the explanatory variables are significant and signed as expected. The significance of D t_ 1 suggests that dividends do not evolve according to a random walk and that firms maintain a stable dividend policy. The coefficient of EPS implies that, in the long run, firms will distribute £0.20 from each £1.00 o f earnings. 12 This is consistent with the observed average dividend pay-out ratio over the sample period of 23%. Although the general trend of the dividend equation is driven by the level of earnings and the lagged dependent variable (i.e., the original Lintner model), the reported results show that both the tax discrimination variable and the tax exhaustion variable exert significant impact on the level of dividend payment. The coefficient of TX implies that if a firm is tax exhausted, then its level of per-share dividend is likely to be lower than if it is paying corporation tax. As expected, the high tax cost of dividend resulting from the irrecoverability of the tax credit encourages tax exhausted companies to pay lower dividends. Since tax exhaustion originates from the existence of other tax allowances, our results suggest that in making their dividend decisions, companies evaluate their level of tax shields. The coefficient of the tax discrimination variable implies that a 1% reduction in the average marginal income tax rate, with z and s constant, will result in a 0.015% increase in dividends and in a 0.09% rise in the long-run in the optimal level of dividends. 13 Moreover, since the value of TD reflects the directors
11 The significance of the F-statistic implies that individual companies' intercepts are not the same making the OLS estimates not consistent. The Lagrange Multiplier and the Hausman test reject the fixed effect model in favour of the generalized least squares model where time and firm effects are embodied in the error term. See Judge et al. (1985) ch. 13 for details. 12 In Eq. (8) the long-run response of dividends to earnings, y, is equal to /31/(1 -/32). 13The long-run response of the tax discrimination variable is f13/(1 - f12).
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holdings, our results provide support for Eckbo and Verma (1994) findings and imply that the higher the proportion of shares held by managers the lower the distribution. 14 As we note in Section 4.4, the positive relationship between the tax discrimination variable and the level of dividends is not a spurious result that can be directly tied to the existence of dividend clientele. Furthermore, the fact that the constant term becomes negative only when the tax discrimination variable is introduced into our estimated equation implies that firms are likely to reduce the level of their dividends to minimize income tax liability of their shareholders. In line with previous U K studies (Edward et al., 1987; Lomax, 1990) our results show that taxation affects firms' dividend policy. The significance of the two tax variables suggests that low payout firms are those unable to recover their A C T and those owned by high income tax payers, i.e., firms with high dividend tax burden. 4.2. Impact o f taxation on ex-day share price behat~iour 1~ Table 2 reports the daily abnormal returns ( A R ) around the ex-day (t = 0) and the cumulative abnormal returns (CAR) from day - 4 0 to day + 40. The results show a substantial and significant ex-day returns of 1.9% (t = 3.32) implying that ex-day share prices drop by significantly less than the amount of dividend. These findings are not driven by extreme observations as the median is 1.55% with 71% positive excess returns. Consistent with previous studies (e.g. Eades et al., 1984; Barclay, 1987; Shaw, 1991), our results reject the null hypothesis of no excess returns on the ex-day and counter the arguments that shareholders are indifferent to the differential taxation of dividend and capital gains (e.g., Miller and Scholes, 1978). Table 2 also shows that, in contrast to previous US studies (e.g., Lakonishok and Vermaelen, 1986; Michaely, 1991), none of the returns before or after the ex-day is significant. These findings are substantiated by the relative stability and non-significance of the CARs around the ex-day. From day - 4 0 up to day + 40 no significant drift in cumulative abnormal returns is observed. Similarly, the CARs of the period - 5 to - 1 are 0.98% ( t = 0.765) and from day + 1 to + 5 amount to - 0 . 4 9 6 ( t = - 0 . 4 3 2 ) . This suggests that the abnormal performance, which is confined solely to the ex-dividend day, is likely to result from the differential taxation of dividends and capital gains.
14When the proportion of directors holdings is introduced into equation 9 to replace TD, its coefficient is - 0.007 (t = - 3.18). 15 The reported results in this section are based on Brown and Warner (1985) event study methodology using the market model with the parameters a and /3 obtained from the OLS regression over the estimating period [ - 200, -41] trading days relative to the ex-day. Tests using mean-adjusted returns, adjusted market model and market model based on Dimson (1979) estimators did not alter the statistical significance of our results.
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Table 2 Daily percentage abnormal returns (AR%) and cumulative abnormal returns (CAR) around ex-day of a sample of 108 UK Companies over the period 1980-1983. Day
AR%
t-stat.
-40 -39 -38 -37 -36 -35 -34 -33 -32 -31 -30 -29 - 28 -27 -26 -25 -24 -23 -22 - 21 - 20 - 19 -18 -17 - 16 - 15 - 14 -13 - 12 -11 - 10 -9 - 8 -7 - 6 - 5 - 4 -3 -2 - 1 0
0.072 0.13 -0.080 -0.14 -0.118 -0.21 -0.043 -0.07 0.163 0.28 -0.013 -0.02 -0.008 -0.01 -0.192 -0.34 -0.090 -0.16 0.013 0.02 0.110 0.19 0.322 0.56 0.035 0.06 -0.048 -0.08 0.244 0.43 0.160 0.28 -0.010 -0.02 0.006 0.01 -0.021 -0.04 0.037 0.06 0.017 0.03 0.156 0.27 -0.069 -0.12 -0.050 -0.09 0.244 0.43 0.184 0.32 0.003 0.01 -0.005 -0.01 0.031 0.05 0.218 0.38 0.158 0.27 -0.194 -0.34 0.224 0.39 0.137 0.24 0.414 0.72 0.463 0.81 0.304 0.53 -0.141 -0.25 0.239 0.42 0.117 0.20 1.904 * 3.32
%Pos
CAR
t-stat.
Day
AR
45.22 48.00 46.26 51.65 50.61 45.74 44.17 43.83 44.17 44.87 44.00 50.43 46.09 45.39 53.22 45.56 49.56 46.43 49.22 46.96 41.04 46.78 44.00 44.00 49.39 49.22 47.65 48.00 50.09 52.35 46.61 39.83 50.09 47.13 52.00 44.52 49.04 44.52 51.83 50.43 71.17
0.072 -0.008 -0.126 -0.168 -0.006 -0.018 -0.026 -0.218 -0.308 -0.295 -0.185 0.136 0.172 0.124 0.368 0.528 0.518 0.525 0.503 0.540 0.558 0.713 0.645 0.595 0.839 1.023 1.026 1.021 1.052 1.271 1.428 1.235 1.459 1.596 2.010 2.473 2.776 2.635 2.874 2.991 4.895
0.13 -0.01 -0.13 -0.15 0.00 -0.01 -0.02 -0.13 -0.18 -0.16 -0.10 0.07 0.08 0.06 0.17 0.23 0.22 0.22 0.20 0.21 0.21 0.27 0.23 0.21 0.29 0.35 0.34 0.34 0.34 0.40 0.45 0.38 0.44 0.48 0.59 0.72 0.80 0.74 0.80 0.82 1.33
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40
-0.345 -0.138 0.004 0.051 -0.068 0.137 -0.098 0.040 0.192 0.160 -0.090 0.222 -0.046 0.106 -0.036 -0.067 -0.260 0.092 0.033 0.040 0.010 -0.071 0.109 -0.100 0.096 -0.277 -0.226 -0.037 -0.049 -0.200 0.100 -0.156 -0.168 0.086 0.398 0.041 -0.192 -0.005 -0.004 -0.037
t-stat. -0.6 -0.2 0.01 0.09 -0.1 0.24 -0.2 0.07 0.33 0.28 -0.2 0.39 -0.1 0.19 -0.1 -0.1 -0.4 0.16 0.06 0.07 0.02 -0.1 0.19 -0.2 0.17 -0.5 -0.4 -0.1 -0.1 -0.3 0.17 -0.3 -0.3 0.15 0.69 0.07 -0.3 -0.0 -0.0 -0.1
%Pos
CAR
t-stat.
37.7 40.5 44.2 42.6 43.6 48.3 45.7 51.5 56.0 43.0 40.7 45.9 42.1 48.3 45.8 43.3 43.7 47.8 51.5 48.3 47.4 44.6 49.0 44.4 43.7 41.8 38.3 43.2 45.2 38.0 45.9 41.9 43.9 45.7 50.2 43.9 43.1 45.3 44.0 46.9
4.55 4.41 4.41 4.46 4.39 4.53 4.43 4.47 4.67 4.83 4.74 4.96 4.91 5.02 4.98 4.92 4.66 4.75 4.78 4.82 4.83 4.76 4.87 4.77 4.87 4.59 4.36 4.33 4.28 4.08 4.18 4.02 3.85 3.94 4.34 4.38 4.19 4.18 4.18 4.14
1.2 1.17 1.16 1.16 1.13 1.15 1.12 1.11 1.15 1.18 1.15 1.19 1.17 1.18 1.16 1.14 1.07 1.08 1.08 1.08 1.07 1.05 1.06 1.03 1.04 0.98 0.92 0.91 0.89 0.84 0.86 0.82 0.78 0.79 0.87 0.87 0.83 0.82 0.81 0.80
The average daily prediction errors measured around the event day (i.e., the first day shares are quoted exdividend, denoted as t = 0) are calculated as the difference between the actual return and the expected return computed using the market model (Brown and Warner, 1985) with the market index return on day t defined as the Financial Times Actuaries All Share Index. Returns from business days - 2 0 0 to - 4 1 are used to obtain ordinary least squares estimates of model parameters. The abnormal returns are averaged over all securities for each day in the relevant event period and then cumulated for periods around the ex-day to obtain CARs. The t-statistics (t-stat.) are computed as the ratio of the abnormal returns to the standard deviation of returns over the estimating period. % Pos.: Percentage of positive abnormal returns. * Significant at 0.01 level.
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4.3. Implications for tax and short-term trading hypotheses If ex-day share prices are affected by taxes, then ex-day returns should be related to dividend yield weighted by the tax differential of dividends to capital gains. If, on the other hand, short-term traders capture dividends, then ex-day returns should reflect the level of transaction costs incurred by these traders. Transaction costs data is not available in machine readable form in the UK. However, Stoll and Whaley (1983) argued that transaction costs are inversely related to firm size as measured by its market value. Following Karpoff and Walkling (1988), we use firm's market value as a proxy for transaction costs. A regression of ex-day abnormal returns against dividend yield and size provides the following result: ARex j = - 0.035 + 0.75DYj + 0.0011n(ME)j (-1.30)
(12.31)
(t-statistics in parentheses)
~2 =
0.228
(1.02) (10)
where ARexj represents the abnormal returns arising on the ex-divided day on security j, D Y and In(ME) are the corresponding dividend yield and the logged cum-dividend market value. The strong and positive relationship between ex-day returns and dividend yield provide support for the tax hypothesis. The coefficient of dividend yield variable of 0.75 reflects the differential taxation of dividend and capital gains, (m - z ) / ( 1 z). For example, at an average effective capital gains tax rate of 14% (Table 1), the implied marginal income tax on dividend, m, of 78% is in line with the higher rate of income tax of 60% plus the investment income surcharge of 15% levied during our sample period. 16 In contrast, when size is the sole explanatory variable in Eq. (10), its coefficient is not significant and R 2 decreases to 0.015. This suggests that ex-day returns are not affected by short-term trading activity. To investigate these results further, a descriptive analysis of the ex-day returns is provided in Table 3. Panel A shows ex-day returns for the sample as a whole and Panel B and Panel C report ex-day returns sorted by dividend yield and size, respectively. 17 Panel A of table 3 shows that, for the sample as a whole, ex-day returns are significantly different from zero, in favour of the hypothesis of an ex-day tax premium. The results based on dividend yield ( D Y ) quintiles (Table 3, Panel B) show a significant shift in abnormal returns from one group of dividend -
16Similar results are obtained using ex-day raw returns. The coefficientof dividend yield is 0.71 with a t-statistics of 15.5 and an adjusted R 2 of 30.5%. The implied marginal income tax rate on dividends is 74.5%. The full results are available on request. 17Gross dividend yield is the ratio of annual dividend to the cum-dividend price. Gross dividend yield categories are: less than 3%, 3%, between 4% and 5%, between 6% and 7% and higher than 8% (inclusive). Similar results are also obtained using equal quintiles.
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M.A. Lasfer /Journal of Banking & Finance 20 (1996) 455-472
Table 3 Descriptive analysis of the ex-day abnormal returns (AR%) for 550 London Stock Exchange ex-dividend observations over 1980-83 period Data
N
AR%
t-stat.
Median %
Panel A. Average All Panel B. Average Q1 (low) Q2 Q3 Q4 Q5 (high) Panel C. Average Q1 (low) Q2 Q3 Q4 Q5 (high)
ex-day returns for the sample as a whole 550 1.90 * 11.68 1.55 ex-day returns ranked by dividend yield 162 0.48 ' 2.24 0.24 108 0.55 * 2.27 0.81 151 2.08 ' 6.62 2.00 75 3.65 * 9.79 3.30 54 6.13 * 8.52 5.39 ex-day returns ranked by market value of equity 110 3.24 * 6.40 2.60 110 2.08 * 5.54 2.0l 110 1.48 * 5.57 1.77 110 1.47 * 4.51 1.03 110 1.24 * 4.82 0.09
% Positive 71 54 68 76 91 92 73 75 69 70 69
Notes: Abnormal returns are computed using the market model. The model parameters are calculated from an ordinary least square regressions of firm's returns against returns on the Financial Times Actuaries All Share Index over the period - 200 to - 41 days relative to the ex-dividend day. In panel B, data is sorted by gross dividend yield. The cut-off points are: QI: less than 3%, Q2: 3%, Q3: from 4 to 5%, Q4: from 6 to 7% and Q5: more than 8%, inclusive. In Panel C, data is sorted on equal size quintiles. Size is defined as the market value of equity the day before share are quoted ex-dividend. N is the number of observations, t-stat, is the Student-test statistic for significance of the cross-sectional mean abnormal returns and All is for the total sample. * Significant at 0.01 level.
yield c o m p a n i e s to a n o t h e r . T h e a b n o r m a l r e t u r n s i n c r e a s e m o n o t o n i c a l l y f r o m 0 . 4 8 % for the s m a l l e s t d i v i d e n d yield g r o u p to 6 . 1 3 % for the largest yield c o m p a n i e s . T h i s p o s i t i v e m o n o t o n i c r e l a t i o n s h i p b e t w e e n d i v i d e n d yield a n d a b n o r m a l r e t u r n s is d i s c e r n i b l e in all g r o u p s a n d p r o v i d e s e v i d e n c e o f the tax e f f e c t s o n e x - d a y prices. I f e x - d a y r e t u r n s are a f f e c t e d b y s h o r t - t e r m t r a d i n g t h e n w e e x p e c t a b n o r m a l r e t u r n s o f large f i r m s to b e l o w e r a n d to reflect l e v e l s o f t r a n s a c t i o n costs r a t h e r t h a n tax differentials. P a n e l C o f T a b l e 3 s h o w s that, w h e n the data are s o r t e d b y size, e x - d a y r e t u r n s d e c r e a s e f r o m 3 . 2 4 % for the p o r t f o l i o o f s m a l l c o m p a n i e s to 1 . 2 4 % for the largest firms. H o w e v e r , u n l i k e the d i v i d e n d yield c a t e g o r i e s , the d i f f e r e n c e s in a b n o r m a l r e t u r n s r a n k e d b y size are not significant. 18 T h e s e f i n d i n g s are n o t c o n s i s t e n t w i t h the s h o r t - t e r m t r a d i n g h y p o t h e s i s , a result that is p r o b a b l y d u e to the a n t i - d i v i d e n d c a p t u r e legislation. T h i s legal r e s t r i c t i o n a n d the
18 For example, the difference between the yield groups Q2 and Q5 is significant (t = -7.34) while that of size groups is not significant (t = 1.85). Detailed results are available on request.
M~A. Lasfer / Journal of Banking & Finance 20 (1996) 455-472
469
Table 4 Analysis of the drop-off ratio by dividend yield quintiles Dividend yield quintiles
N
Less than 3% Equal to 3% 4% to 5% 6% to 7% Higher than 8% All
t-stat, b
S.D.
0.438 0.580 0.442 0.433 0.327
-0.29 - 3.18 - 9.02 - 10.53 - 10.32
2.934 0.911 0.691 0.505 0.443
0.443
- 4.92
1.708
Mean
Median
DOR ex
DOR ex
162 108 151 75 54
0.934 0.721 0.493 0.386 0.365
550
0.641 ab
The drop-off ratio, DORex, is the ratio of the difference between the price of a share the day before the ex-day and its price on the ex-day to the gross dividend. N is the number of observations in each gross dividend yield quintile. b t-statistics for mean drop-off ratio is equal to unity.
high income tax rates in the UK are likely to explain our relatively higher ex-day returns compared to those found in the US. 19
4.4. Implications for dividend clientele The dividend clientele hypothesis states that firm's dividend policy is independent of the tax position of its shareholders and, for a given set of dividend policies, investors are expected to hold portfolios chosen on the basis of their after-tax rates of return. If this is the case, then ex-day share prices of high yield securities should not decrease by less than the amount of the dividend because these securities are expected to be held by low-tax-paying investors. Consequently, ex-day returns associated with high-yield shares should be low. In contrast to these expectations, the positive and monotonic relationship between ex-day returns and dividend yield reported in Table 3 and Eq. (10) imply that the decrease in ex-day share prices is much lower for high dividend yield shares relative to low yield shares. These results are further substantiated by the analysis of the drop-off ratio reported in Table 4. In line with previous studies (Kaplanis, 1986), we find that ex-day share prices decrease, on average, by 64% of gross dividend. However, inconsistent with the tax-induced dividend clienteles hypothesis, the highest dividend yield group's average drop-off of 0.365 is significantly higher than unity (t = -10.32). These results provide support for Booth and Johnston (1984) and Poterba and Summers (1984) findings and suggest that firms consider their shareholders' tax position when setting their dividend policies.
19 See Lakonishok and Vermaelen (1986), Karpoff and Walkling (1988, 1990) for an analysis of short-term trading in the US.
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M.A. Lasfer /Journal of Banking & Finance 20 (1996) 455-472
5. Conclusion This paper tests the simultaneous effect of both the corporation tax and personal income taxes on the dividend policy of a sample of UK listed companies. We show that, under the imputation system, the overall tax burden on dividends and capital gains borne by the firm and its shareholders is inversely proportional to the firm's payout ratio when the tax credit is recoverable and shareholders are tax-exempt or taxed at the standard rate of income tax. However, when shareholders are taxed at a higher rate of income tax a n d / o r ACT is not recoverable, the overall tax burden on dividends and capital gains increases with the payout ratio. We, thus, hypothesize that firms should set their dividend policies to minimize their tax liability and to maximise the after-tax return of their shareholders and that ex-day share prices should decrease by less than the amount of the dividend to reflect the differential taxation of dividends and capital gains. The reported results show that taxation affects both the payout policy and ex-day returns. We find that tax exhaustion reduces the level of dividends paid by firms while a lower tax burden on dividends in the hands of shareholders appears to encourage firms to pay higher dividends. Furthermore, consistent with the tax effects, ex-day returns are positive and significantly related to dividend yield and not to transaction costs as proxied by firm's size. We find no evidence of a tax-induced dividend clientele effect, result that is consistent with the proposition that firm's dividend policy is affected by its shareholders' tax position.
Acknowledgements I am grateful to two anonymous referees for insightful suggestions that greatly improved this article. I have benefited from helpful comments from Gordon Gemmill, Mario Levis, Sudi Sudarsanam, Richard Tamer, John Lomax, Daniella Acker, David Ashton, Michael Theobald, participants at the 1992 British Accounting Association Conference, the 1992 French Finance Association Annual Meeting, the 1993 British Academy of Management Conference, the City University Business School seminars and especially from comments received from Dylan Thomas. Mario Levis provided me with a copy of the statistical software to conduct one portion of this study. I am grateful for his help. The usual disclaimers apply.
References Barclay, M.J., 1987, Dividends, taxes and common stock prices: The ex-dividend day behaviour of common stock prices before the income tax, Journal of Financial Economics 19, 31-43.
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Booth, L.D. and D.J. Johnston, 1984, The ex-dividend day behaviour of Canadian stock prices: Tax changes and clientele effects, Journal of Finance 39, 457-476. Brown, S. and J. Warner, 1985, Using daily stock return: The case of event studies, Journal of Financial Economics 14, 3-32. CSO, 1990, The 1989 Share Register Survey (HMSO: Central Statistical Office, London). Devereux, M., 1987, Taxation and the cost of capital: The UK experience, Oxford Review of Economic Policy 3, 17-32. Dimson, E., 1979, Risk measurement when shares are subject to infrequent trading, Journal of Financial Economics 7, 197-226. Eades, K.M., P.J. Hess and E.H. Kim, 1984, On interpreting security returns during the ex-dividend period, Journal of Financial Economics 13, 3-34. Eckbo, B.E., and S. Verma, 1994, Managerial shareownership, voting power and cash dividend policy, Journal of Corporate Finance 1, 33-62. Edwards, J.S.S., C.P. Mayer, P. Pashades and J.M. Poterba, 1987, The effects of taxation on corporate dividend policy in the UK (IFS Working Paper No. 96). Edwards, J.S.S. and C.P. Mayer, 1983, Issues in bank taxation (IFS Report Series No 5). Elton, E. and M. Gruber, 1970, Marginal stockholder tax rates and the clientele effect, Review of Economics and Statistics 52, 68-74. Elton, E., M. Gruber and J. Rentzler, 1984, The ex-dividend day behaviour of stock prices: A reexamination of the clientele effect: A comment, Journal of Finance 39, 551-556. Greene, W.H., 1993, Econometric analysis, 2nd ed. (Macmillan, New York). Judge, G.G., W.E. Griffiths, R.C. Hill, H. Liitkepohl and T.C. Lee, 1985, The theory and practice of econometrics, 2nd ed. (Wiley, New York) Kalay, A., 1982, The ex-dividend day behaviour of stock prices: A re-examination of the clientele effect, Journal of Finance 37, 1059-1070. Kaplanis, C.P., 1986, Options, taxes and ex-dividend day behaviour, Journal of Finance 41,411-424. Karpoff, J. and R. Walkling, 1988, Short term trading around ex-dividend days: Additional evidence, Journal of Financial Economics 21, 291-298. Karpoff, J. and R. Walkling, 1990, Dividend capture in NASDAO stocks, Journal of Financial Economics 28, 39-65. Keim, D.B., 1988, Stock market regularities: A synthesis of the evidence and explanations, in: E. Dimson, ed., Stock market anomalies (Cambridge University Press, Cambridge). King, M.A., 1977, Public policy and the corporation (Chapman and Hall, London). King, M., N. Naldrett and J. Poterba, 1984 The UK tax system, in: M. King and D. Fullerton, eds., The taxation of income from capital (University of Chicago Press, Chicago). Lakonishok, J. and T. Vermaelen, 1983, Tax reforms and ex-dividend day behaviour, Journal of Finance 38, 1157-1179. Lakonishok, J. and T. Vermaelen, 1986, Tax induced trading around ex-dividend days, Journal of Financial Economics 16, 287-319. Lintner, J., 1956, Distribution of income of corporations among dividends, retained earnings and taxes, American Economic Review 46, 97-113. Lomax, J.W., 1990, A model of ICCs' dividend payments (Bank of England Discussion Paper No. 52). Menyah, K., 1993, Ex-dividend equity pricing under UK tax regimes, Journal of Business Finance and Accounting 20, 61-82. Michaely, R., 1991, Ex-dividend day stock price behaviour: The case of the 1986 Tax Reform Act, Journal of Finance 46, 845-859. Miller, M., 1986, Behavioral rationality in finance: The case of dividends, Journal of Business 59, $451-$468. Miller, M, and M. Scholes, 1978, Dividends and taxes, Journal of Financial Economics 6, 333-364. Orhnial, A.J.P, and L.P. Foldes, 1975, Estimates of marginal tax rates for dividends and bond interest in the United Kingdom 1919-1970, Econometrica 42, 79-91.
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Poterba, J.M. and L.H. Summers, 1985, The economics effect of dividend taxation, in: Altman E.I. and M.G. Subrahmanyam, eds., Recent advances in corporate finance (Irwin, New York). Poterba, J.M. and L.H. Summers, 1984, New evidence that taxes affect the valuation of dividends, Journal of Finance, 39, 1397-1415. Shaw, W.H., 1991, An examination of ex-dividend day stock price movements: The case of Nontaxable Master Limited Partnership distribution, Journal of Finance 46, 755-771. Stock Exchange (The), 1982, Survey of share ownership (Stock Exchange, London). Stock Exchange (The), 1991, The current state of share ownership, Stock Exchange Quarterly, Summer 1991. Stoll, H. and R. Whaley, 1983, Transaction costs and the small firm effect, Journal of Financial Economics 12, 57-79.
Journal of Banking & Finance 20 (1996) 455-472
Journalof BANKING & FINANCE
Taxes and dividends: The UK evidence M. Ameziane Lasfer * Centre for Empirical Research in Finance and Accounting, City Unwersity Business School, Barbican Centre, London, EC2Y 8HB, UK
Received 15 December 1993; accepted 15 January 1995
Abstract This paper provides empirical evidence on the simultaneous effects of both corporation and personal income taxes on dividend payment adjustments and on the behaviour of share prices on the ex-dividend dates. The results show that companies set their dividend policies to minimise their tax liability and to maximise the after-tax return of their shareholders. In particular, firms that are unable to deduct the advanced corporation tax from their tax liability are found to pay low dividends. In addition, consistent with the tax hypothesis, we find that the differential taxation of dividends and capital gains results in a decrease in ex-day share prices by significantly less than the amount of the dividend. There is no evidence of a tax-induced dividend clientele. JEL classification: G35 Keywords: Dividend policy; Ex-day price behaviour; Imputation tax system; Personal taxes
I. Introduction The tax implication of a particular d i v i d e n d policy is perhaps the principal challenge to the d i v i d e n d irrelevance proposition. Both corporate taxes and
* Tel. (+ 44) (0) 171 477 8634, Fax. (+ 44) (0) 171 477 8648, e-mail: M.A. [email protected]. 0378-4266/96/$15.00 © 1996 Elsevier Science B.V. All rights reserved SSDI 0 3 7 8 - 4 2 6 6 ( 9 5 ) 0 0 0 1 2 - 7
456
M.A. Lasfer /Journal of Banking & Finance 20 (1996) 455-472
personal income taxes are expected to affect firm's dividend payout ratios, its subsequent share price movements and the composition of its shareholders. However, despite the theoretical impact of taxation on dividends, little or conflicting empirical evidence has been provided to date. For instance, in the dividend literature we find no tax analysis that can explain the cross-sectional or time-series variations in dividend payments made by individual companies. The empirical studies on the effect of taxes on returns do not all support the view that shares with greater tax exposure tend to sell at lower prices and have greater expected pre-tax rates of return. Furthermore, it is not clear whether the tax effects that motivate the model occur at a single point in time, such as the ex-day, or are spread over a longer time period, i Moreover, the Elton and Gruber (1970) hypothesis that the differential taxation of dividend and capital gains is reflected in the drop in the ex-day share prices is difficult to test because of possible simultaneous short-term trading effects (e.g. Kalay, 1982). None of the previous work considers the joint effects of corporate taxes and personal income taxes on dividend payments. The purpose of this paper is to contribute to the dividend literature by analysing the simultaneous effects of both corporate taxes and personal income taxes on the firm's dividend decision and its ex-day share price behavior. The UK environment provides an ideal framework for studying this issue as the imputation system alleviates part of the double taxation on dividend and provides a link between the tax treatment of dividend at firm and at individual shareholder levels. We model this link and show that, in the absence of a tax-induced dividend clientele, firm's dividend policy depends on corporate and personal taxes. Using panel data and an appropriate statistical methodology to account for cross-sectional and time-series differences in taxes and in other explanatory variables, we find that companies set their dividend policies to minimise their tax liability and to maximise the after-tax return of their shareholders. In particular, firms that are unable to deduct the advanced corporation tax from their tax liability are found to pay low dividends. Also, consistent with the proposition that taxes affect equilibrium share prices on the ex-dividend date, we find that ex-day share prices drop by less than the amount of the dividend and ex-day returns are positively and monotonically distributed across dividend yields, though no tax-induced dividend clientele is observed. The rest of the paper is organized as follows. In Section 2, we develop the hypotheses. In Section 3, we describe the data and the methodology. In Section 4, we present an analysis of the empirical results. Conclusions are set out in Section 5.
i See Miller (1986) and Keim (1988) for a review of these studies.
M.A. Lasfer /Journal of Banking & Finance 20 (1996) 455-472
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2. Theoretical background and hypotheses tested 2.1. Taxes and corporate dividend payment The tax burden on dividends depends on both corporate and personal income tax systems. 2 In a classical system, the total tax is the sum of the corporation tax, the effective capital gains tax and the tax on dividends. Typically, the tax on dividends exceeds the gains tax creating an incentive to reduce dividends. In an imputation system, on the other hand, the total tax is given by the corporation tax plus the effective gains tax plus the reduced dividend tax. If the reduction in the tax on dividend is large enough to make reduced dividend tax lower than the effective capital gains tax, an incentive to increase dividends is created. Under the imputation system, a firm that distributes a net dividend in cash of, say, d must, in addition, pay the advanced corporation tax (ACT) equal to the basic rate of income tax on the gross dividend. If s is the standard rate of income tax, the gross dividend, D, is defined as d / ( 1 - s ) and A C T is sD, i.e., s d / ( 1 - s). The A C T is first paid to the tax authorities fourteen days after the end of the quarter in which the dividend is paid and then deducted from the firm's corporation tax liability which is usually payable nine months after the end of the accounting period. Shareholders pay tax mD, where m is their personal rate of income tax and receive a tax credit of sD. Thus, shareholders' dividend tax is ( m - s)D, i.e., d ( m - s ) / ( 1 - s). For investors taxed at m < s dividend is not taxed or tax subsidized. Only individuals taxed at m > s pay a dividend tax. For example, if the cash dividend, d, is £7.00 and s = 30%, the tax credit is £3.00. Tax-exempt institutions claim the full tax credit and their after-tax dividend is £10.00. Investors taxed at the basic income tax rate have no additional dividend tax to pay. Individuals with tax rate m of, say, 40% are only subject to an additional income tax demand of £1.00 and their after-tax dividend is £6.00. In this case, the effective dividend tax is 14.3% ( ( 4 0 % - 3 0 % ) / ( 1 - 3 0 % ) ) . Cash dividends received by corporate investors from other U K companies are not taxed again as a profit. The associated tax credit cannot be refunded by the tax authorities but corporate investors can use it to frank their own dividend payments or offset it against their previous tax liability. Assuming an effective corporation tax rate of r c, the dividend tax burden is. therefore, the sum of corporate tax paid, r~d/(1 - re), and the individual taxes paid, d(m - s ) / ( 1 - s), as a percentage of the pre-corporate-tax dividend, d / ( l re): ~d d(m-s) - - + 1 -% 1-s (1- re)(1-m) =1(1) d 1-s 1-r c On the other hand, if earnings are retained and reinvested at the cost of capital,
2 Detailed analysis of dividend tax systems are in King (1977). Poterba and Summers (1985).
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they would generate an after-tax capital gains of r(1 - z ) where r is the firm's after-tax earnings that are retained and z is the effective capital gains tax rate. The capital gains tax burden is the sum of the corporate tax paid, % r/(1 - %), and the individual tax rz, all divided by the precorporate-tax capital gains, r'r~
--+rz
1--~-c r
= 1 - (1 - ~'c)(1 - z )
(2)
1-% The overall tax burden on dividend and retained earnings borne by the firm and its shareholders can be derived as the weighted average of the dividends and capital gains tax burdens as a proportion of the firm's payout ratio and can be defined as: d[ --
(1 - re)(1 - m) ] 1-
=1-(1-~-c)
( +
~
]2 s
d) 1-
[1-(m-rc)(1-z)]
(l-z)
+(l-z)
(3)
where d/E is the firm's payout ratio and E are earnings. Eq. (3) implies that the overall tax burden on dividends and capital gains is a function of the corporation tax, the dividend payout ratio and the differential taxation of dividends and capital gains. Let TD = (1 - m)/[(1 - s)(1 - z)] represent this tax discrimination variable (King, 1977) and rearranging, Eq. (3) becomes:
1 - ( 1 - "Cc)(1- z){ d [ T D - 1 ] + l}
(4)
Thus, when dividend tax is equal to the tax on capital gains, TD is unity and the overall tax burden is invariant with respect to t~e payout ratio. However, when TD is higher (lower) than one, the overall tax burden decreases (increases) as the payout ratio increases. TD varies with the income tax rate of individual investor. For example, tax-exempt investors (m = z = 0), given a corporation tax rate of 52% and a standard rate of income tax of 30%, will have a tax discrimination factor of 1.43 and a tax burden on dividends of 31.4% compared to a 52% tax burden if earnings are retained. For individuals taxed at m = s = 30% and at an effective capital gains tax of, say, 20%, TD is 1.25 and the dividend tax amounts to 52% while the capital gains tax burden rises to 61.6%. This implies that both tax-exempt investors and basic income taxpayers are expected to favour dividends. However, for investors taxed at a higher income tax rate, TD is less than one and their dividends bear higher tax than retained earnings. These investors will only
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favour dividends if the effective capital gains tax rate, z, is higher than the additional dividend tax, i.e., z > (m - s ) / ( 1 - s). In practice the imputation system is fully operational only when ACT is recovered, i.e., when dividends are not paid from profits generated abroad and taxable profits exceed gross dividends. In the 1970s and early 1980s other corporate tax allowances, such as capital allowances and stock relief, reduced significantly firms' present and future taxable profits to below their gross dividend payments. These allowances led companies to be tax exhausted where their corporation tax liability is nil or negative and their ACT is unrelieved (e.g. Devereux, 1987; Edwards et al., 1987). Unrelieved ACT can normally be set against the corporation tax payments of the two previous years or carried forward to offset against future corporation tax liabilities. However, if its recoverability is not reasonably certain and foreseeable in the future, A C T is directly written off in firms' accounts increasing the tax cost on dividends and resulting in a higher tax burden on dividends relative to the implied tax on retained earnings. For example, from Eq. (3), any dividend paid by tax exhausted firms for which, say, ~'c = 0, to tax-exempt investors (whose m = z = 0) carries a tax burden of s / ( 1 - s ) compared to the tax burden on capital gains of 0. The above tax arguments imply that, where dividend tax-clienteles do not prevail, as shown in Section 4.4 below, a firm is expected to set its dividend policy to minimize its tax liability and to maximize the after-tax return of its shareholders. 2.2. Taxes and ex-day share price behaviour Taxes are also expected to affect the equilibrium share price behaviour on the day when shares are first quoted ex-dividend (the ex-day). Elton and Gruber (1970) show that, when dividends are taxed at a higher rate than capital gains, ex-day share prices drop by less than the amount of the dividend and the drop-off ratio reflects the tax differential between dividends and capital gains. In the UK, although dividends carry a tax credit, they are effectively taxed at a higher rate than capital gains. Until 1984, investment income above a threshold was subject to a surcharge of 15%. This, for example, caused the dividend in 1979, when received by an investor paying the top rate of income tax of 83%, to be effectively taxed at 98% less the tax credit of 35%, i.e., 63% compared to the standard capital gains tax rate of 30%. Although, the higher rate of income tax was reduced in 1980 to 60% and the basic rate to 30%, the tax burden on dividend of 45% (60% + 15% - 30%) was still higher than even the standard capital gains tax of 30%. Given this tax differential, we expect ex-day share prices to decrease by less than the amount of dividend resulting in positive ex-day returns. Taxes are not, however, the sole determinants of ex-day returns. When ex-day returns are positive, investors whose dividend income and capital gains are taxed equally, are expected to buy securities before the ex-day and sell them after they go ex-dividend reducing ex-day returns to zero (e.g., Kalay, 1982). Elton et al.
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(1984) argue, however, that, in this case, the observed ex-day drop may only understate the size of the tax effect because the magnitude of the price decline will be capped by the transaction costs involved in short-term trading. In the UK, however, short-term trading is unlikely to occur because of institutional regulation and potential tax penalties 3. However, this legislation will only reduce, not eliminate, short-term trading (e.g., Menyah, 1993). If short-term traders do capture dividends, then we expect ex-day returns to be randomly distributed around zero but positive before the ex-day and negative thereafter.
3. Sample selection and methodology 3.1. Sample description
The initial sample of the firms provided by E X S T A T data base met three criteria. First, to ensure that dividends are paid from profits generated in the UK, firms are selected on condition that their main activities are concentrated in the U K domestic market. Second, companies must have a continuous daily price quotation on the London Stock Exchange and have their accounting data available for the full sample period in Exstat, Extel Cards and Datastream. Financial companies are excluded because of their special tax treatment. 4 Third, the ex-day and the announcement day must be separated by at least five calendar days so that the ex-day abnormal returns are not distorted by announcement effects. With the exception of these conditions, the selection of firms is random, covering a wide range of companies from various industries. The final sample consists of 108 industrial and commercial companies for the period 1973 to 1983, resulting in 1188 pooled observations. 5 The lack of data on daily share prices has restricted the sample period used in the analysis of returns to 1980-83, a total of 550 ex-day returns (246 interim and 304 final dividends). The effective corporate tax rates are calculated for each individual company using a computer based tax model that takes into account all allowances and reliefs that existed during the sample period as well as previous losses and ACT.
3 The anti-tax avoidance legislation prevents dealers, tax-exempt institutions and individuals from trading around the ex-day for the sole purpose of capturing dividends and/or avoiding taxes. See Poterba and Summers (1984, p. 1402) for details on the 1970Anti-Avoidance Act. 4 See Edwards and Mayer (1983) for bank taxation. 5 Our sample covers an average of 5% of the total number of firms in EXSTAT (15% of live companies during all the sample period) and 18% of the total market value. It includes small companies as well as the large domestic firms. The earliest data available in EXSTAT is 1972. The sample period is constrained by the 1984 UK Corporation Tax Reform where companies are able to elect a set of tax allowances for a transitory period of 3 years. In the post-1984 period, it was not possible to make generalized comparisons across companies.
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We define a dummy variable of one to represent those companies for which taxable profits are lower than gross dividends. These companies are considered to be tax exhausted and their A C T is assumed to be irrecoverable. The tax discrimination variable is computed as follows. The basic income tax rates are the rates that prevailed during the sample period. Shareholders are assumed to face the same effective capital gains tax rate. The statutory capital gains tax rate is computed from The Inland Revenue Statistics. Following King (1977), we use a value of 10% for the proportion of accrued gains realized in each year and compute the effective capital gains tax rates by discounting these statutory rates using the redemption yield on long dated government stocks. ~ The marginal income tax rate, m, is function of both the composition and the holdings of the different shareholders. To compute m we group shareholders into three main groups according to their tax treatment: tax-exempt institutions, insurance companies and individuals. The first group includes pension funds, pension business of insurance companies and charities. The second group, taxed at a special rate, includes funds such as life insurance policies invested by insurance companies for their clients. The third group includes direct household share ownership and indirect ownership through taxed intermediaries such as mutual funds and banks. From companies' reports and Extel cards, we obtain the proportion of shares held by individuals, financial institutions and corporate investors. We then classify these according to the above three categories so that the appropriate tax rates can be applied. The household group (including directors' interests both beneficial and non-beneficial 7) is assumed to be taxed at the higher rate of income tax. For the remaining proportion of shareholders not disclosed in companies' reports, we use the aggregate weighted average tax rates for each class of shareholders. To compute the aggregate weights, we use U K surveys on share ownership (CSO, 1989; Stock Exchange, 1982, 1991) and extrapolate the trend to cover our sample period. 8 The proportion of each g r o u p ' s holdings is added to the percentage disclosed in the firm's account to find the most likely holdings of this category for the firm in question. 9 For the household group, we compute the average income tax rates from The Inland Revenue Statistics where the distribution of share ownership is
6 Alternative annual turnover rates than the 10% did not change significantly our results. 7 When such non-beneficial holdings are, for instance, as joint trustec with one other person of a pension fund, this proportion is considered to be tax exempt. 8 These surveys find that, from 1969 to 1989, institutional holding rose from 9% to 30.4% household's share declined from 47.4% to 21.3%. See King et al. (1984) and King (1977) for a detailed description of the procedures used in deriving the respective tax rates. 9 For instance, if a firm reports that insurance companies hold 8%, individuals 12% and tax exempt institutions 10% and if, at the aggregate, insurance companies hold 20%, then the likely holding of the insurance group in this firm is 22% (8% + (100%- 8 % - 12%- 10%)× 20%).
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Table 1 Descriptive statistics on pooled time-series and cross-sectional means of the tax variables for a sample of 108 industrial and commercial companies over the period 1973-1983. Variables
Mean
Median
S.D.
Minimum
Maximum
Tc ~c TX m Zs z s TD
0.503 0.203 0.290 0.434 0.282 0.139 0.323 0.969
0.520 0.173 0.000 0.426 0.291 0.137 0.330 0.994
0.041 0.188 0.454 0.064 0.019 0.011 0.022 0.102
0.300 0.000 0.000 0.360 0.246 0.121 0.300 0.222
0.520 0.520 1.000 0.868 0.300 0.160 0.350 1.083
Notes: Tc is the standard corporation tax rate adjusted for small companies' rates; r c is the effective corporation tax rate computed for each company using a computer tax model taking into account all the allowances and reliefs as well as previous losses and the advanced corporation tax (ACT) a; TX is the tax exhaustion dummy variable equal to 1 if the taxable profit is lower than gross dividends and, thus, ACT is unrelieved; m is the marginal income tax on dividend computed using the various shareholders' tax categories and respective holdings in each firm; Zs is the standard capital gains tax rate computed as the ratio of capital gains payments over the amount of capital gains (data are from the Inland Revenue Statistics); z is the effective capital gains tax rate calculated by discounting the statutory rates using the redemption yield on long-dated government stocks b; s is the basic rate of income tax; TD is the tax discrimination variable equal to (1 - m)/[(1 - z)(1 - s)]; S.D. is the standard deviation. a If taxable profit, defined as profit before tax less allowances and reliefs, is not positive then losses are set off against previous two years' profit, or carried forward to subsequent year. A value of 10% is taken as the proportion of accrued capital gains realised in each year.
r e l a t e d to the total i n c o m e t a x e s p a i d b y e a c h s h a r e h o l d e r g r o u p ( O r h n i a l a n d Foldes, 1975; K i n g , 1977). T h e d e f i n i t i o n o f s h a r e o w n e r s h i p m a y s u f f e r f r o m the n o n - a l l o c a t i o n o f n o m i n e e h o l d i n g s , a c a s e w h e r e i n s t i t u t i o n s s u c h as b a n k s h o l d s h a r e s as i n t e r m e d i a r i e s . T o o v e r c o m e this p r o b l e m , the n o m i n e e s r e p o r t e d in c o m p a n i e s ' a c c o u n t s are a l l o c a t e d to the t h r e e s h a r e h o l d e r s ' c a t e g o r i e s u s i n g the a b o v e s u r v e y s ' f i n d i n g s . A l t h o u g h t h e s e s u r v e y s trace b a c k all n o m i n e e h o l d i n g s to t h e i r u l t i m a t e b e n e f i c i a l o w n e r , they are o n l y c a r r i e d o u t at 6 - y e a r i n t e r v a l s a n d w e rely o n the e x t r a p o l a tion o f t h e i r f i n d i n g s to c o v e r o u r s a m p l e period. T a b l e 1 r e p o r t s the d e s c r i p t i v e statistics o f the tax v a r i a b l e s u s e d in this study. T h e e f f e c t i v e c o r p o r a t i o n tax rates are s i g n i f i c a n t l y l o w e r t h a n the s t a n d a r d rates (the t-statistic o f the d i f f e r e n c e b e t w e e n the t w o m e a n s is - 5 3 . 6 ) . T h e tax e x h a u s t i o n d u m m y v a r i a b l e s h o w s that in 2 9 % o f the c a s e s A C T is i r r e c o v e r a b l e . T h e m e a n tax d i s c r i m i n a t i o n v a r i a b l e , TD, is 0.97. T h i s result i n d i c a t e s that, o n a v e r a g e , t h e r e is n o b i a s for d i v i d e n d s o v e r capital gains. H o w e v e r , the m a x i m u m v a l u e o f 1.08 a n d the m i n i m u m o f 0 . 2 2 s u g g e s t that t h e r e are c a s e s w h e r e t h e r e is a d i s t i n c t p r e f e r e n c e for e i t h e r d i v i d e n d s or capital gains.
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3.2. M e t h o d o l o g y
To investigate the impact of taxation on corporate dividend distribution behaviour, the Lintner (1956) specification is modified to incorporate both the tax exhaustion and the tax discrimination variables. The effects of these tax variables cannot be analyzed in the Lintner's parameters because tax exhaustion depends on taxable profit not reported earnings and tax discrimination variable is not constant through time. The original Lintner model suggests that firms determine their desired dividends in any period, D * , by relating a target pay-out ratio to current reported earnings. We assume that the target pay-out ratio is function of the firm's and shareholders' marginal tax rates, as represented in the following model:
(5)
0 7 = y E P S t + ~ T X t + 0 TD t + I.tt
where E P S t is the earnings per share at time t, T X t is the tax exhaustion dummy variable and T D is the tax discrimination variable. 10 /z is the error term with zero mean and constant variance. This equilibrium relationship indicates that a firm will not change its level of dividends unless one or more of the exogenous variables has changed. In any one year, a firm is assumed to adjust partially to the desired level of dividend payment and that the change in dividend per share from t - 1 to t, ( D t - Dr_ 1), is:
Dt-Dt-1
=/30 +
A(D,* - D r _ l )
+ at
(6)
The constant, /3o, is expected to be positive to reflect the reluctance of companies to reduce their dividend payments and their desire for a gradual growth in the level of dividends (Lintner, 1956). The speed of adjustment, A, is expected to reflect the degree of movement toward the new target. Combining Eqs. (5) and (6) we obtain:
Dt =/30 q- A y E P S t + (1
-
A ) D t _ 1 d- A O T D t + A 6 T X t + e t
(7)
Defining /31 = Ay; /32 = (1 - h); /33 = A0 and /34 = AS, the estimated equation is Dt =/30 + / 3 1 E P S , + / 3 2 D t - 1 +/33TDt +/34TXt + et
(8)
From the above analysis we expect /30 , /31, /32 and /33 to be positive and /34 negative.
10 TX measures the firm's corporation tax position while TD measures the personal income tax rate of its shareholders. These two tax variables are independent because firms pay ACT irrespective of their taxable profit and their shareholders are deemed to have received the cash dividend and the tax credit. The correlation between TX and TD is -0.016, not significant.
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4. Empirical results 4.1. Impact of taxation on firm's dividend adjustment Ordinary least-squares method cannot be used to estimate the above dividend equation because the method assumes that the coefficients are not affected by time or unit observation. For our panel data, this assumption is violated. Instead, we use the generalized least squares method (e.g. Greene, 1993; Judge et al., 1985) and obtain the following results:
Dit = - 0.011 + O.034EPSit + 0.831Dit_ 1 + O.015TDit - O.O02TXit (-2.29) ,~2 = 0.862
(18.9)
(66.2)
F-statistic = 2.336
(3.27)
(-2.62)
(9)
L - M = 71.33 H = 175.38
(t-statistics in parentheses) where L - M is the Lagrange Multiplier and H is the Hausman test. it Eq. (9) shows that the coefficients of the explanatory variables are significant and signed as expected. The significance of D t_ 1 suggests that dividends do not evolve according to a random walk and that firms maintain a stable dividend policy. The coefficient of EPS implies that, in the long run, firms will distribute £0.20 from each £1.00 o f earnings. 12 This is consistent with the observed average dividend pay-out ratio over the sample period of 23%. Although the general trend of the dividend equation is driven by the level of earnings and the lagged dependent variable (i.e., the original Lintner model), the reported results show that both the tax discrimination variable and the tax exhaustion variable exert significant impact on the level of dividend payment. The coefficient of TX implies that if a firm is tax exhausted, then its level of per-share dividend is likely to be lower than if it is paying corporation tax. As expected, the high tax cost of dividend resulting from the irrecoverability of the tax credit encourages tax exhausted companies to pay lower dividends. Since tax exhaustion originates from the existence of other tax allowances, our results suggest that in making their dividend decisions, companies evaluate their level of tax shields. The coefficient of the tax discrimination variable implies that a 1% reduction in the average marginal income tax rate, with z and s constant, will result in a 0.015% increase in dividends and in a 0.09% rise in the long-run in the optimal level of dividends. 13 Moreover, since the value of TD reflects the directors
11 The significance of the F-statistic implies that individual companies' intercepts are not the same making the OLS estimates not consistent. The Lagrange Multiplier and the Hausman test reject the fixed effect model in favour of the generalized least squares model where time and firm effects are embodied in the error term. See Judge et al. (1985) ch. 13 for details. 12 In Eq. (8) the long-run response of dividends to earnings, y, is equal to /31/(1 -/32). 13The long-run response of the tax discrimination variable is f13/(1 - f12).
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holdings, our results provide support for Eckbo and Verma (1994) findings and imply that the higher the proportion of shares held by managers the lower the distribution. 14 As we note in Section 4.4, the positive relationship between the tax discrimination variable and the level of dividends is not a spurious result that can be directly tied to the existence of dividend clientele. Furthermore, the fact that the constant term becomes negative only when the tax discrimination variable is introduced into our estimated equation implies that firms are likely to reduce the level of their dividends to minimize income tax liability of their shareholders. In line with previous U K studies (Edward et al., 1987; Lomax, 1990) our results show that taxation affects firms' dividend policy. The significance of the two tax variables suggests that low payout firms are those unable to recover their A C T and those owned by high income tax payers, i.e., firms with high dividend tax burden. 4.2. Impact o f taxation on ex-day share price behat~iour 1~ Table 2 reports the daily abnormal returns ( A R ) around the ex-day (t = 0) and the cumulative abnormal returns (CAR) from day - 4 0 to day + 40. The results show a substantial and significant ex-day returns of 1.9% (t = 3.32) implying that ex-day share prices drop by significantly less than the amount of dividend. These findings are not driven by extreme observations as the median is 1.55% with 71% positive excess returns. Consistent with previous studies (e.g. Eades et al., 1984; Barclay, 1987; Shaw, 1991), our results reject the null hypothesis of no excess returns on the ex-day and counter the arguments that shareholders are indifferent to the differential taxation of dividend and capital gains (e.g., Miller and Scholes, 1978). Table 2 also shows that, in contrast to previous US studies (e.g., Lakonishok and Vermaelen, 1986; Michaely, 1991), none of the returns before or after the ex-day is significant. These findings are substantiated by the relative stability and non-significance of the CARs around the ex-day. From day - 4 0 up to day + 40 no significant drift in cumulative abnormal returns is observed. Similarly, the CARs of the period - 5 to - 1 are 0.98% ( t = 0.765) and from day + 1 to + 5 amount to - 0 . 4 9 6 ( t = - 0 . 4 3 2 ) . This suggests that the abnormal performance, which is confined solely to the ex-dividend day, is likely to result from the differential taxation of dividends and capital gains.
14When the proportion of directors holdings is introduced into equation 9 to replace TD, its coefficient is - 0.007 (t = - 3.18). 15 The reported results in this section are based on Brown and Warner (1985) event study methodology using the market model with the parameters a and /3 obtained from the OLS regression over the estimating period [ - 200, -41] trading days relative to the ex-day. Tests using mean-adjusted returns, adjusted market model and market model based on Dimson (1979) estimators did not alter the statistical significance of our results.
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Table 2 Daily percentage abnormal returns (AR%) and cumulative abnormal returns (CAR) around ex-day of a sample of 108 UK Companies over the period 1980-1983. Day
AR%
t-stat.
-40 -39 -38 -37 -36 -35 -34 -33 -32 -31 -30 -29 - 28 -27 -26 -25 -24 -23 -22 - 21 - 20 - 19 -18 -17 - 16 - 15 - 14 -13 - 12 -11 - 10 -9 - 8 -7 - 6 - 5 - 4 -3 -2 - 1 0
0.072 0.13 -0.080 -0.14 -0.118 -0.21 -0.043 -0.07 0.163 0.28 -0.013 -0.02 -0.008 -0.01 -0.192 -0.34 -0.090 -0.16 0.013 0.02 0.110 0.19 0.322 0.56 0.035 0.06 -0.048 -0.08 0.244 0.43 0.160 0.28 -0.010 -0.02 0.006 0.01 -0.021 -0.04 0.037 0.06 0.017 0.03 0.156 0.27 -0.069 -0.12 -0.050 -0.09 0.244 0.43 0.184 0.32 0.003 0.01 -0.005 -0.01 0.031 0.05 0.218 0.38 0.158 0.27 -0.194 -0.34 0.224 0.39 0.137 0.24 0.414 0.72 0.463 0.81 0.304 0.53 -0.141 -0.25 0.239 0.42 0.117 0.20 1.904 * 3.32
%Pos
CAR
t-stat.
Day
AR
45.22 48.00 46.26 51.65 50.61 45.74 44.17 43.83 44.17 44.87 44.00 50.43 46.09 45.39 53.22 45.56 49.56 46.43 49.22 46.96 41.04 46.78 44.00 44.00 49.39 49.22 47.65 48.00 50.09 52.35 46.61 39.83 50.09 47.13 52.00 44.52 49.04 44.52 51.83 50.43 71.17
0.072 -0.008 -0.126 -0.168 -0.006 -0.018 -0.026 -0.218 -0.308 -0.295 -0.185 0.136 0.172 0.124 0.368 0.528 0.518 0.525 0.503 0.540 0.558 0.713 0.645 0.595 0.839 1.023 1.026 1.021 1.052 1.271 1.428 1.235 1.459 1.596 2.010 2.473 2.776 2.635 2.874 2.991 4.895
0.13 -0.01 -0.13 -0.15 0.00 -0.01 -0.02 -0.13 -0.18 -0.16 -0.10 0.07 0.08 0.06 0.17 0.23 0.22 0.22 0.20 0.21 0.21 0.27 0.23 0.21 0.29 0.35 0.34 0.34 0.34 0.40 0.45 0.38 0.44 0.48 0.59 0.72 0.80 0.74 0.80 0.82 1.33
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40
-0.345 -0.138 0.004 0.051 -0.068 0.137 -0.098 0.040 0.192 0.160 -0.090 0.222 -0.046 0.106 -0.036 -0.067 -0.260 0.092 0.033 0.040 0.010 -0.071 0.109 -0.100 0.096 -0.277 -0.226 -0.037 -0.049 -0.200 0.100 -0.156 -0.168 0.086 0.398 0.041 -0.192 -0.005 -0.004 -0.037
t-stat. -0.6 -0.2 0.01 0.09 -0.1 0.24 -0.2 0.07 0.33 0.28 -0.2 0.39 -0.1 0.19 -0.1 -0.1 -0.4 0.16 0.06 0.07 0.02 -0.1 0.19 -0.2 0.17 -0.5 -0.4 -0.1 -0.1 -0.3 0.17 -0.3 -0.3 0.15 0.69 0.07 -0.3 -0.0 -0.0 -0.1
%Pos
CAR
t-stat.
37.7 40.5 44.2 42.6 43.6 48.3 45.7 51.5 56.0 43.0 40.7 45.9 42.1 48.3 45.8 43.3 43.7 47.8 51.5 48.3 47.4 44.6 49.0 44.4 43.7 41.8 38.3 43.2 45.2 38.0 45.9 41.9 43.9 45.7 50.2 43.9 43.1 45.3 44.0 46.9
4.55 4.41 4.41 4.46 4.39 4.53 4.43 4.47 4.67 4.83 4.74 4.96 4.91 5.02 4.98 4.92 4.66 4.75 4.78 4.82 4.83 4.76 4.87 4.77 4.87 4.59 4.36 4.33 4.28 4.08 4.18 4.02 3.85 3.94 4.34 4.38 4.19 4.18 4.18 4.14
1.2 1.17 1.16 1.16 1.13 1.15 1.12 1.11 1.15 1.18 1.15 1.19 1.17 1.18 1.16 1.14 1.07 1.08 1.08 1.08 1.07 1.05 1.06 1.03 1.04 0.98 0.92 0.91 0.89 0.84 0.86 0.82 0.78 0.79 0.87 0.87 0.83 0.82 0.81 0.80
The average daily prediction errors measured around the event day (i.e., the first day shares are quoted exdividend, denoted as t = 0) are calculated as the difference between the actual return and the expected return computed using the market model (Brown and Warner, 1985) with the market index return on day t defined as the Financial Times Actuaries All Share Index. Returns from business days - 2 0 0 to - 4 1 are used to obtain ordinary least squares estimates of model parameters. The abnormal returns are averaged over all securities for each day in the relevant event period and then cumulated for periods around the ex-day to obtain CARs. The t-statistics (t-stat.) are computed as the ratio of the abnormal returns to the standard deviation of returns over the estimating period. % Pos.: Percentage of positive abnormal returns. * Significant at 0.01 level.
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4.3. Implications for tax and short-term trading hypotheses If ex-day share prices are affected by taxes, then ex-day returns should be related to dividend yield weighted by the tax differential of dividends to capital gains. If, on the other hand, short-term traders capture dividends, then ex-day returns should reflect the level of transaction costs incurred by these traders. Transaction costs data is not available in machine readable form in the UK. However, Stoll and Whaley (1983) argued that transaction costs are inversely related to firm size as measured by its market value. Following Karpoff and Walkling (1988), we use firm's market value as a proxy for transaction costs. A regression of ex-day abnormal returns against dividend yield and size provides the following result: ARex j = - 0.035 + 0.75DYj + 0.0011n(ME)j (-1.30)
(12.31)
(t-statistics in parentheses)
~2 =
0.228
(1.02) (10)
where ARexj represents the abnormal returns arising on the ex-divided day on security j, D Y and In(ME) are the corresponding dividend yield and the logged cum-dividend market value. The strong and positive relationship between ex-day returns and dividend yield provide support for the tax hypothesis. The coefficient of dividend yield variable of 0.75 reflects the differential taxation of dividend and capital gains, (m - z ) / ( 1 z). For example, at an average effective capital gains tax rate of 14% (Table 1), the implied marginal income tax on dividend, m, of 78% is in line with the higher rate of income tax of 60% plus the investment income surcharge of 15% levied during our sample period. 16 In contrast, when size is the sole explanatory variable in Eq. (10), its coefficient is not significant and R 2 decreases to 0.015. This suggests that ex-day returns are not affected by short-term trading activity. To investigate these results further, a descriptive analysis of the ex-day returns is provided in Table 3. Panel A shows ex-day returns for the sample as a whole and Panel B and Panel C report ex-day returns sorted by dividend yield and size, respectively. 17 Panel A of table 3 shows that, for the sample as a whole, ex-day returns are significantly different from zero, in favour of the hypothesis of an ex-day tax premium. The results based on dividend yield ( D Y ) quintiles (Table 3, Panel B) show a significant shift in abnormal returns from one group of dividend -
16Similar results are obtained using ex-day raw returns. The coefficientof dividend yield is 0.71 with a t-statistics of 15.5 and an adjusted R 2 of 30.5%. The implied marginal income tax rate on dividends is 74.5%. The full results are available on request. 17Gross dividend yield is the ratio of annual dividend to the cum-dividend price. Gross dividend yield categories are: less than 3%, 3%, between 4% and 5%, between 6% and 7% and higher than 8% (inclusive). Similar results are also obtained using equal quintiles.
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Table 3 Descriptive analysis of the ex-day abnormal returns (AR%) for 550 London Stock Exchange ex-dividend observations over 1980-83 period Data
N
AR%
t-stat.
Median %
Panel A. Average All Panel B. Average Q1 (low) Q2 Q3 Q4 Q5 (high) Panel C. Average Q1 (low) Q2 Q3 Q4 Q5 (high)
ex-day returns for the sample as a whole 550 1.90 * 11.68 1.55 ex-day returns ranked by dividend yield 162 0.48 ' 2.24 0.24 108 0.55 * 2.27 0.81 151 2.08 ' 6.62 2.00 75 3.65 * 9.79 3.30 54 6.13 * 8.52 5.39 ex-day returns ranked by market value of equity 110 3.24 * 6.40 2.60 110 2.08 * 5.54 2.0l 110 1.48 * 5.57 1.77 110 1.47 * 4.51 1.03 110 1.24 * 4.82 0.09
% Positive 71 54 68 76 91 92 73 75 69 70 69
Notes: Abnormal returns are computed using the market model. The model parameters are calculated from an ordinary least square regressions of firm's returns against returns on the Financial Times Actuaries All Share Index over the period - 200 to - 41 days relative to the ex-dividend day. In panel B, data is sorted by gross dividend yield. The cut-off points are: QI: less than 3%, Q2: 3%, Q3: from 4 to 5%, Q4: from 6 to 7% and Q5: more than 8%, inclusive. In Panel C, data is sorted on equal size quintiles. Size is defined as the market value of equity the day before share are quoted ex-dividend. N is the number of observations, t-stat, is the Student-test statistic for significance of the cross-sectional mean abnormal returns and All is for the total sample. * Significant at 0.01 level.
yield c o m p a n i e s to a n o t h e r . T h e a b n o r m a l r e t u r n s i n c r e a s e m o n o t o n i c a l l y f r o m 0 . 4 8 % for the s m a l l e s t d i v i d e n d yield g r o u p to 6 . 1 3 % for the largest yield c o m p a n i e s . T h i s p o s i t i v e m o n o t o n i c r e l a t i o n s h i p b e t w e e n d i v i d e n d yield a n d a b n o r m a l r e t u r n s is d i s c e r n i b l e in all g r o u p s a n d p r o v i d e s e v i d e n c e o f the tax e f f e c t s o n e x - d a y prices. I f e x - d a y r e t u r n s are a f f e c t e d b y s h o r t - t e r m t r a d i n g t h e n w e e x p e c t a b n o r m a l r e t u r n s o f large f i r m s to b e l o w e r a n d to reflect l e v e l s o f t r a n s a c t i o n costs r a t h e r t h a n tax differentials. P a n e l C o f T a b l e 3 s h o w s that, w h e n the data are s o r t e d b y size, e x - d a y r e t u r n s d e c r e a s e f r o m 3 . 2 4 % for the p o r t f o l i o o f s m a l l c o m p a n i e s to 1 . 2 4 % for the largest firms. H o w e v e r , u n l i k e the d i v i d e n d yield c a t e g o r i e s , the d i f f e r e n c e s in a b n o r m a l r e t u r n s r a n k e d b y size are not significant. 18 T h e s e f i n d i n g s are n o t c o n s i s t e n t w i t h the s h o r t - t e r m t r a d i n g h y p o t h e s i s , a result that is p r o b a b l y d u e to the a n t i - d i v i d e n d c a p t u r e legislation. T h i s legal r e s t r i c t i o n a n d the
18 For example, the difference between the yield groups Q2 and Q5 is significant (t = -7.34) while that of size groups is not significant (t = 1.85). Detailed results are available on request.
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Table 4 Analysis of the drop-off ratio by dividend yield quintiles Dividend yield quintiles
N
Less than 3% Equal to 3% 4% to 5% 6% to 7% Higher than 8% All
t-stat, b
S.D.
0.438 0.580 0.442 0.433 0.327
-0.29 - 3.18 - 9.02 - 10.53 - 10.32
2.934 0.911 0.691 0.505 0.443
0.443
- 4.92
1.708
Mean
Median
DOR ex
DOR ex
162 108 151 75 54
0.934 0.721 0.493 0.386 0.365
550
0.641 ab
The drop-off ratio, DORex, is the ratio of the difference between the price of a share the day before the ex-day and its price on the ex-day to the gross dividend. N is the number of observations in each gross dividend yield quintile. b t-statistics for mean drop-off ratio is equal to unity.
high income tax rates in the UK are likely to explain our relatively higher ex-day returns compared to those found in the US. 19
4.4. Implications for dividend clientele The dividend clientele hypothesis states that firm's dividend policy is independent of the tax position of its shareholders and, for a given set of dividend policies, investors are expected to hold portfolios chosen on the basis of their after-tax rates of return. If this is the case, then ex-day share prices of high yield securities should not decrease by less than the amount of the dividend because these securities are expected to be held by low-tax-paying investors. Consequently, ex-day returns associated with high-yield shares should be low. In contrast to these expectations, the positive and monotonic relationship between ex-day returns and dividend yield reported in Table 3 and Eq. (10) imply that the decrease in ex-day share prices is much lower for high dividend yield shares relative to low yield shares. These results are further substantiated by the analysis of the drop-off ratio reported in Table 4. In line with previous studies (Kaplanis, 1986), we find that ex-day share prices decrease, on average, by 64% of gross dividend. However, inconsistent with the tax-induced dividend clienteles hypothesis, the highest dividend yield group's average drop-off of 0.365 is significantly higher than unity (t = -10.32). These results provide support for Booth and Johnston (1984) and Poterba and Summers (1984) findings and suggest that firms consider their shareholders' tax position when setting their dividend policies.
19 See Lakonishok and Vermaelen (1986), Karpoff and Walkling (1988, 1990) for an analysis of short-term trading in the US.
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5. Conclusion This paper tests the simultaneous effect of both the corporation tax and personal income taxes on the dividend policy of a sample of UK listed companies. We show that, under the imputation system, the overall tax burden on dividends and capital gains borne by the firm and its shareholders is inversely proportional to the firm's payout ratio when the tax credit is recoverable and shareholders are tax-exempt or taxed at the standard rate of income tax. However, when shareholders are taxed at a higher rate of income tax a n d / o r ACT is not recoverable, the overall tax burden on dividends and capital gains increases with the payout ratio. We, thus, hypothesize that firms should set their dividend policies to minimize their tax liability and to maximise the after-tax return of their shareholders and that ex-day share prices should decrease by less than the amount of the dividend to reflect the differential taxation of dividends and capital gains. The reported results show that taxation affects both the payout policy and ex-day returns. We find that tax exhaustion reduces the level of dividends paid by firms while a lower tax burden on dividends in the hands of shareholders appears to encourage firms to pay higher dividends. Furthermore, consistent with the tax effects, ex-day returns are positive and significantly related to dividend yield and not to transaction costs as proxied by firm's size. We find no evidence of a tax-induced dividend clientele effect, result that is consistent with the proposition that firm's dividend policy is affected by its shareholders' tax position.
Acknowledgements I am grateful to two anonymous referees for insightful suggestions that greatly improved this article. I have benefited from helpful comments from Gordon Gemmill, Mario Levis, Sudi Sudarsanam, Richard Tamer, John Lomax, Daniella Acker, David Ashton, Michael Theobald, participants at the 1992 British Accounting Association Conference, the 1992 French Finance Association Annual Meeting, the 1993 British Academy of Management Conference, the City University Business School seminars and especially from comments received from Dylan Thomas. Mario Levis provided me with a copy of the statistical software to conduct one portion of this study. I am grateful for his help. The usual disclaimers apply.
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