literature on dividends has been to investigate whether there is a tax effect:All else equal,we ask if firms that pay out high dividends are less valuable than firms that pay out low dividends. Two basic ideas are important to understanding how to interpret the results of these investigations: 1 Static clientele models: (① Different groups,or "clienteles,"are taxed differently.Miller and Modigliani (1961)argued that firms have an incentive to supply stocks that minimize the taxes of each clientele.In equilibrium,no further possibilities for reducing taxes will exist and all firms will be equally priced. (i) A particular case (labeled as the simple static model)is when all investors are taxed the same way,and capital gains are taxed less than dividend income.In this case,the optimal policy is not to pay dividends.Firms with high dividend yields would be worth less than equivalent firms with low dividend yields. 2. Dynamic clientele model:If investors can trade through time,tax liabilities can be reduced even further.The dividend-paying stock will end up (just before the ex-dividend day)in the hands of those who are taxed the least when the dividend is received.Such trades will be reversed directly after the ex-day The empirical studies of dividend policy have tried to distinguish between the different versions of these models by attempting to identify one or more of the following: (①) Is there a tax effect so that low-dividend-paying stocks are more valuable than high dividend stocks? 21
literature on dividends has been to investigate whether there is a tax effect: All else equal, we ask if firms that pay out high dividends are less valuable than firms that pay out low dividends. Two basic ideas are important to understanding how to interpret the results of these investigations: 1. Static clientele models: (i) Different groups, or "clienteles," are taxed differently. Miller and Modigliani (1961) argued that firms have an incentive to supply stocks that minimize the taxes of each clientele. In equilibrium, no further possibilities for reducing taxes will exist and all firms will be equally priced. (ii) A particular case (labeled as the simple static model) is when all investors are taxed the same way, and capital gains are taxed less than dividend income. In this case, the optimal policy is not to pay dividends. Firms with high dividend yields would be worth less than equivalent firms with low dividend yields. 2. Dynamic clientele model: If investors can trade through time, tax liabilities can be reduced even further. The dividend-paying stock will end up (just before the ex-dividend day) in the hands of those who are taxed the least when the dividend is received. Such trades will be reversed directly after the ex-day. The empirical studies of dividend policy have tried to distinguish between the different versions of these models by attempting to identify one or more of the following: (i) Is there a tax effect so that low-dividend-paying stocks are more valuable than high dividend stocks? 21
(ii） Do static tax clienteles exist so that the marginal tax rates of high-dividend stockholders are lower than those of low-dividend stockholders? (ii） Do dynamic tax clienteles exist so that there is a large volume around the ex- dividend day,and low-tax-rate investors actually receive the dividend? This literature has traditionally been divided into CAPM-based studies and ex-dividend day studies.In our view,more insight is gained by comparing static to dynamic models.In the static models,investors trade only once.Thus,with the objective of minimizing taxes(keeping all else constant),investors must make a long-term decision about their holdings.The buy-and- hold CAPM studies,such as Litzenberger and Ramaswamy (1979),and Miller and Scholes (1982),fall into this category.The Elton and Gruber(1970)study is similar in that respect. Investors are allowed to trade only once,either on the cum-day or on the ex-day,but not on both. As we shall show,a static view is appropriate when transaction costs are exceedingly high,or when tax payments have been reduced to zero in the static clientele model. In contrast,in dynamic models,investors are allowed to take different positions at different times.These models take into account risk,taxes,and transaction costs.Just before the ex-day,dividend-paying stocks can flow temporarily to the investors who value them the most. 5.1 Static models First,we look at the special case in which all investors are taxed in the same way and the tax rate on dividend income is higher than the tax rate on capital gains income.In otherwise perfect capital markets,the optimal policy is to pay no dividends.Equityholders are better off receiving profits through repurchases or selling their shares so that they pay capital gains taxes rather than the higher taxes on dividends.Most U.S.corporations have not followed this 22
(ii) Do static tax clienteles exist so that the marginal tax rates of high-dividend stockholders are lower than those of low-dividend stockholders? (iii) Do dynamic tax clienteles exist so that there is a large volume around the exdividend day, and low-tax-rate investors actually receive the dividend? This literature has traditionally been divided into CAPM-based studies and ex-dividend day studies. In our view, more insight is gained by comparing static to dynamic models. In the static models, investors trade only once. Thus, with the objective of minimizing taxes (keeping all else constant), investors must make a long-term decision about their holdings. The buy-andhold CAPM studies, such as Litzenberger and Ramaswamy (1979), and Miller and Scholes (1982), fall into this category. The Elton and Gruber (1970) study is similar in that respect. Investors are allowed to trade only once, either on the cum-day or on the ex-day, but not on both. As we shall show, a static view is appropriate when transaction costs are exceedingly high, or when tax payments have been reduced to zero in the static clientele model. In contrast, in dynamic models, investors are allowed to take different positions at different times. These models take into account risk, taxes, and transaction costs. Just before the ex-day, dividend-paying stocks can flow temporarily to the investors who value them the most. 5.1 Static models First, we look at the special case in which all investors are taxed in the same way and the tax rate on dividend income is higher than the tax rate on capital gains income. In otherwise perfect capital markets, the optimal policy is to pay no dividends. Equityholders are better off receiving profits through repurchases or selling their shares so that they pay capital gains taxes rather than the higher taxes on dividends. Most U.S. corporations have not followed this 22
scenario.For a long time,many firms have paid dividends regularly and have rarely repurchased their shares.On the face of it,this behavior is puzzling,especially if we believe that agents in the market place behave in a rational manner.The basic assumption of this simple static model is that for all investors there is a substantial tax disadvantage to dividends because they are taxed (heavily)as ordinary income,while share repurchases are taxed (lightly)as capital gains But even if the statutory tax rates on dividends and capital gains were equal (and usually, they have not been),from a tax perspective receiving unrealized capital gains is superior to dividend payments. The first reason is that capital gains do not have to be realized immediately,and thus the associated tax can be postponed.An investor's ability to postpone may generate considerable value.Imagine a stock with an expected annual return of 15%,and an investor with a marginal tax rate of 20%on long-term capital gains.Say the investor has $1000 and an investment horizon of ten years,and consider whether she should realize gains at the end of each year or wait and realize all gains at the end of the tenth year.Under the first strategy,her final wealth would be $3,106.Under the second strategy it would be $3,436,a substantial difference. Second,investors can choose when to realize capital gains (unlike dividends,for which they have no choice in the timing).In a more formal setting,Constantinides (1984)showed that investors should be willing to pay for this option to delay capital gains realization,and labeled it the“tax timing option..” In reality,of course,not all investors are taxed as individuals.Many financial institutions,such as pension funds and endowments,do not pay taxes.They have no reason to prefer capital gains to dividends,or vice versa.Individuals hold stocks directly or indirectly,and so do corporations.One of the principal reasons corporations hold dividend-paying stocks as 23
scenario. For a long time, many firms have paid dividends regularly and have rarely repurchased their shares. On the face of it, this behavior is puzzling, especially if we believe that agents in the market place behave in a rational manner. The basic assumption of this simple static model is that for all investors there is a substantial tax disadvantage to dividends because they are taxed (heavily) as ordinary income, while share repurchases are taxed (lightly) as capital gains. But even if the statutory tax rates on dividends and capital gains were equal (and usually, they have not been), from a tax perspective receiving unrealized capital gains is superior to dividend payments. The first reason is that capital gains do not have to be realized immediately, and thus the associated tax can be postponed. An investor’s ability to postpone may generate considerable value. Imagine a stock with an expected annual return of 15%, and an investor with a marginal tax rate of 20% on long-term capital gains. Say the investor has $1000 and an investment horizon of ten years, and consider whether she should realize gains at the end of each year or wait and realize all gains at the end of the tenth year. Under the first strategy, her final wealth would be $3,106. Under the second strategy it would be $3,436, a substantial difference. Second, investors can choose when to realize capital gains (unlike dividends, for which they have no choice in the timing). In a more formal setting, Constantinides (1984) showed that investors should be willing to pay for this option to delay capital gains realization, and labeled it the “tax timing option.” In reality, of course, not all investors are taxed as individuals. Many financial institutions, such as pension funds and endowments, do not pay taxes. They have no reason to prefer capital gains to dividends, or vice versa. Individuals hold stocks directly or indirectly, and so do corporations. One of the principal reasons corporations hold dividend-paying stocks as 23
both a form of near-cash assets and as an investment is because under the U.S.tax code,a large fraction of intercorporate dividends are exempt from taxation,but intercorporate (or government) interest payments are not.Under the old tax code,only 15%of dividends,deemed taxable income,were taxed,so the effective tax rate on dividends received was 0.15 x 0.46(marginal corporate tax rate)=6.9%.But corporations had to pay the full amount of taxes on any realized gains.Under the current tax code,30%of dividends are taxed. In a clientele model,taxpayers in different groups hold different types of assets,as illustrated in the stylized example below.Individuals hold low-dividend-payout stocks. Medium-dividend-payout firms are owned by people who can avoid taxes,or by tax-free institutions.Corporations own high-dividend-payout stocks.Firms must be indifferent between the three types of stock,or they would increase their value by issuing more of the type that they prefer. How are assets priced in this model?Since firms must be indifferent between the different types of assets,the assets must be priced so they are equally desirable.To show how this works,we use the following example: Suppose there are three groups that hold stocks: Prior to the 1986 Tax Reform Act(TRA),individual investors who held a stock for at least six months paid a lower tax on capital gains(20%)than on ordinary dividends(50%).The TRA eliminated all distinctions between capital gains and ordinary income.However,it is still possible to defer taxes on capital gains by not realizing the gains. Before the 1986 TRA,a corporation that held the stock of another corporation paid taxes on only 15%of the dividend.Therefore,the effective tax rate for dividend income was 0.15 x 0.46=0.069.After the TRA,the corporation income tax rate was reduced to 34%.The fraction of the dividend exempted from taxes was also reduced to 70%.The effective tax rate for dividend income was therefore increased to 0.3 x 0.34=0.102.In both time periods,the dividend exemption could be as high as 100%if the dividend-paying corporation was a wholly owned subsidiary of the dividend-receiving corporation. 24
both a form of near-cash assets and as an investment is because under the U.S. tax code, a large fraction of intercorporate dividends are exempt from taxation, but intercorporate (or government) interest payments are not. Under the old tax code, only 15% of dividends, deemed taxable income, were taxed, so the effective tax rate on dividends received was 0.15 x 0.46 (marginal corporate tax rate) = 6.9%. But corporations had to pay the full amount of taxes on any realized gains. Under the current tax code, 30% of dividends are taxed.4 In a clientele model, taxpayers in different groups hold different types of assets, as illustrated in the stylized example below. Individuals hold low-dividend-payout stocks. Medium-dividend-payout firms are owned by people who can avoid taxes, or by tax-free institutions. Corporations own high-dividend-payout stocks. Firms must be indifferent between the three types of stock, or they would increase their value by issuing more of the type that they prefer. How are assets priced in this model? Since firms must be indifferent between the different types of assets, the assets must be priced so they are equally desirable. To show how this works, we use the following example: Suppose there are three groups that hold stocks: 4 Prior to the 1986 Tax Reform Act (TRA), individual investors who held a stock for at least six months paid a lower tax on capital gains (20%) than on ordinary dividends (50%). The TRA eliminated all distinctions between capital gains and ordinary income. However, it is still possible to defer taxes on capital gains by not realizing the gains. Before the 1986 TRA, a corporation that held the stock of another corporation paid taxes on only 15% of the dividend. Therefore, the effective tax rate for dividend income was 0.15 x 0.46 = 0.069. After the TRA, the corporation income tax rate was reduced to 34%. The fraction of the dividend exempted from taxes was also reduced to 70%. The effective tax rate for dividend income was therefore increased to 0.3 x 0.34 = 0.102. In both time periods, the dividend exemption could be as high as 100% if the dividend-paying corporation was a wholly owned subsidiary of the dividend-receiving corporation. 24
(①) Individuals who are in high tax brackets and pay high taxes on dividend-paying stocks.These investors are subject to a 50%tax rate on dividend income and a 20%tax rate on capital gains. ( Corporations whose tax situation is such that they pay low taxes on stocks that pay dividends.Their tax rate on dividend income is 10%and is 35%on capital gains. (iii) Institutions that pay no taxes.Their opportunity cost of capital,determined by the return available in investment other than securities,is 10%. Assume that these groups are risk neutral,so risk is not an issue.All that matters is the after-tax returns to the stocks.(We note that in this stylized market,a tax clientele is a result of both the risk neutrality assumption and the trading restrictions.) There are three types of stock.For simplicity,we assume that each stock earnings per share of $100.The only difference between these shares is the form of payout.Table 6 describes the after-tax cash flow for each group if they held each type of stock. In this example,individuals with high tax brackets will hold low-payout shares, corporations will hold the high-payout shares,and institutions will be prepared to hold all three. The asset holdings of these three groups are shown in Table 7. To show why the shares must all have the same price,if the price of low-payout shares was $1050 and the prices of the high-and medium-payout stocks was $1000,what would happen?High-and medium-payout firms would have an incentive to change their dividend policies and increase the supply of low-payout stocks.This change would put downward pressure on the price of low payout stock.What amount of stock do investors demand? Individuals would still be prepared to buy the low-payout stock,since $80/$1050 =7.62%, 25
(i) Individuals who are in high tax brackets and pay high taxes on dividend-paying stocks. These investors are subject to a 50% tax rate on dividend income and a 20% tax rate on capital gains. (ii) Corporations whose tax situation is such that they pay low taxes on stocks that pay dividends. Their tax rate on dividend income is 10% and is 35% on capital gains. (iii) Institutions that pay no taxes. Their opportunity cost of capital, determined by the return available in investment other than securities, is 10%. Assume that these groups are risk neutral, so risk is not an issue. All that matters is the after-tax returns to the stocks. (We note that in this stylized market, a tax clientele is a result of both the risk neutrality assumption and the trading restrictions.) There are three types of stock. For simplicity, we assume that each stock earnings per share of $100. The only difference between these shares is the form of payout. Table 6 describes the after-tax cash flow for each group if they held each type of stock. In this example, individuals with high tax brackets will hold low-payout shares, corporations will hold the high-payout shares, and institutions will be prepared to hold all three. The asset holdings of these three groups are shown in Table 7. To show why the shares must all have the same price, if the price of low-payout shares was $1050 and the prices of the high- and medium-payout stocks was $1000, what would happen? High- and medium-payout firms would have an incentive to change their dividend policies and increase the supply of low-payout stocks. This change would put downward pressure on the price of low payout stock. What amount of stock do investors demand? Individuals would still be prepared to buy the low-payout stock, since $80/$1050 = 7.62%, 25