Tax preference theory

Tax preference theory is one of the major theories concerning dividend policy in an enterprise. It was first developed by R.H. Litzenberger and K. Ramaswamy. This theory claims that investors prefer lower payout companies for tax reasons. They based this theory on observation of American stock market, and presented three major reasons why investors might prefer lower payout companies.

1. Unlike dividend, long-term capital gains allow the investor to defer tax payment until they decide to sell the stock. Because of time value effects, tax paid immediately has a higher effective capital cost than the same tax paid in the future.
2. Up until 1986 in USA all dividend and only 40 percent of capital gains were taxed. At a taxation rate of 50%, this gives us a 50% tax rate on dividends and (0,4)(0,5) = 20% on long-term capital gains. Therefore, investors might want the companies to retain their earnings in order to avoid higher taxes. As of 1989 dividend and capital gains tax rates are equal but deferral issue still remains.
3. If a stockholder dies, no capital gains tax is collected at all. Those who inherit the stocks can sell them on the death day at their base costs and avoid capital gains tax payment.

Influences on dividend decision

The dividend decision is an integral part of a company's financial decision-making as it is explicitly related to the other two major decisions — investment and financing decision. Corporate taxation influences the dividend decision in more than one way. On the one hand, it influences the net income-after-tax of the company, which, in turn, determines the capacity of the company to pay dividends, and, on the other hand, it may have implications for the net value received by the shareholders.

Rate of corporate tax play an important role in determining the dividend policy, amount of dividend declared, distributed or paid by the company. A zero-dividend payout is not uncommon for young rapidly growing companies. However, companies may also be discouraged from paying higher dividends when these are doubly taxed once in the hands of the company and again in the hands of the shareholders. Personal income tax paid on dividend income amounts to a second tax on corporate profits.

Examples related to tax preference theory

• First, investors in high tax brackets may prefer lower payout companies because they can avoid paying the higher taxes associated with dividends. For example, if an investor is in the 35% tax bracket, they may prefer to invest in a company that pays out little or no dividends, as they will avoid paying 35% of the dividend income in taxes.
• Second, investors may also prefer lower payout companies because they can avoid the double taxation of dividends. When a company pays out dividends, the company itself pays taxes on the profits that generated the dividend income, and then the investor must pay taxes on the dividend income they receive. However, if the company does not pay out dividends, the investor can avoid the additional taxes on the dividend income.
• Third, investors may prefer lower payout companies because the reinvested earnings can potentially generate higher returns. Since the company does not pay out dividends, the profits are reinvested into the business, which can potentially lead to higher returns as the company grows and expands. Investors may therefore prefer investing in companies with lower payout ratios as they can potentially generate higher returns.

Advantages of Tax preference theory

• The Tax Preference Theory provides investors with a way to take advantage of the tax benefits associated with lower dividend payouts.
• Investors can benefit from the lower taxes they pay on dividends compared to the higher taxes they pay on capital gains.
• The theory also suggests that investors prefer companies with lower payouts because they can reinvest the dividend income in additional shares, thus increasing their ownership stake.
• Investors also benefit from the higher potential for capital appreciation in lower-paying companies, as their retained earnings can be used to grow the business.
• Finally, tax preference theory suggests that investors may prefer lower payout companies because they offer more stability, since companies with lower payout ratios tend to have more liquid assets, which can be used to help absorb any losses that may occur.

Limitations of Tax preference theory

• One limitation of the tax preference theory is that it does not take into account the correlation between the dividend payout ratio and the tax rate. For example, if a company pays a higher dividend, its shareholders may be subject to a higher tax rate. This could make investors more likely to invest in companies with lower dividend payouts.
• Another limitation of the tax preference theory is that it does not account for the potential benefits of investing in companies with higher dividend payouts. For example, companies with higher dividend payouts may be seen as more stable and have higher growth potential. This could make them attractive investments for investors regardless of the tax implications.
• The tax preference theory also does not take into account investor preferences for different types of investments. For instance, some investors may prefer investments in stocks with higher dividend payouts, while others may prefer investments in stocks with lower dividend payouts. These preferences could affect investor decisions regardless of the tax implications.
• Finally, the tax preference theory does not account for changes in tax rates or other external factors that could influence investor decisions. For example, if tax rates increase, investors may be less likely to prefer stocks with lower dividend payouts. This could affect their decision-making regardless of the tax preference theory.

Other approaches related to Tax preference theory

• Tax preference theory is one of the major theories concerning dividend policy in an enterprise. In addition to this there are other approaches related to dividend policy which include:
• The bird-in-the-hand theory, which suggests that investors prefer current dividends to future dividends.
• The life-cycle theory, which suggests that individuals prefer a higher dividend payout during their retirement years when their income is lower.
• The clientele effect, which suggests that certain investors prefer the stock of certain companies based on their dividend policies.
• The residual dividend policy, which suggests that a company should pay out whatever dividends its profits allow.

Overall, these approaches to dividend policy suggest that investors have different preferences when it comes to dividend payment, and that companies should be aware of these preferences in order to maximize their earnings.

Tax preference theory — recommended articles

Dividend irrelevance theory — Cumulative dividend — Bird-in-the-hand theory — Plowback Ratio — Capital dividend — Degree of financial leverage — Cumulative Preferred Stock — Dividend Recapitalization — Optimal capital structure

References

• Al-Malkawi, H. A. N., Rafferty, M., & Pillai, R. (2010). Dividend policy: A review of theories and empirical evidence. International Bulletin of Business Administration, 9(1), 171-200.
• Baker, H. K., & Powell, G. E. (1999). How corporate managers view dividend policy. Quarterly Journal of Business and Economics, 17-35.
• Eugene F. Brigham, Louis C. Gapenski, Intermediate financial management, The Dryden Press 1990, p. 423-424
• Eugene F. Brigham, Fundamentals of financial management, The Dryden Press, 1992, p. 499-500
• Litzenberger, R. H., & Ramaswamy, K. (1980). Dividends, short selling restrictions, tax‐induced investor clienteles and market equilibrium. The Journal of Finance, 35(2), 469-482.
• Litzenberger, R. H., & Ramaswamy, K. (1982). The Effects of Dividends on Common Stock Prices Tax Effects or Information Effects?. The Journal of Finance, 37(2), 429-443.
• Singhania, M. (2006). Taxation and corporate payout policy. Vikalpa, 31(4), 47.

Author: Michał Pilarczyk