The Effect of Shareholder Taxes on Corporate Payout Choice

Abstract

This study investigates whether the difference in individual shareholder tax rates between dividend income and capital gain (the dividend tax penalty) affects a firm's choice between distributing funds to shareholders through dividends or share repurchases. The results of this study suggest that, in periods in which the dividend tax penalty increases, firms are more likely to distribute funds to shareholders through share repurchases as opposed to dividends. The results also indicate that the relationship between the dividend tax penalty and corporate payout choice is affected by the types of shareholders who own stock in the firm. As managerial share ownership increases and the dividend tax penalty increases firms are more likely to make distributions to shareholders in the form of share repurchases. As aggregate institutional ownership increases and the dividend tax penalty increases, firms are neither more likely to repurchase shares nor more likely to distribute dividends. Division of the institutional ownership category indicates that institutions classified as mutual funds and investment advisors (brokers) have the strongest preference for share repurchases as the dividend tax penalty increases. In contrast, institutions classified as banks, insurance companies and other institutions have the smallest preference for share repurchases as the dividend tax penalty increases. The implication of this study is that individual shareholder taxes affect firms' corporate payout choice.