Tax Differential View of Dividend Policy

What is Tax Differential View of Dividend Policy

The tax differential view of dividend policy is the belief that shareholders prefer equity appreciation to dividends because capital gains are effectively taxed at lower rates than dividends when the investment time horizon and other factors are considered. Corporations that adopt this viewpoint generally have lower targeted payout ratios, or a long-term dividend-to-earnings ratio, as dividend payments are set rather than variable.

Breaking Down Tax Differential View of Dividend Policy

The tax differential view is part of a debate over dividends versus equity growth that is old but still vigorous. The payment of dividends to shareholders can be traced back to the origins of modern corporations. In the 16th century, sailing captains in England and Holland sold shares of their upcoming voyage to investors. At the end of the voyage, whatever capital was earned from trading or plunder would be divided among the investors and the venture shut down. Eventually, it became more efficient to create an ongoing joint stock company, with shares sold on exchanges and dividends allotted per share. Before the advent of rigorous corporate earnings reports, dividends were the most reliable way to capitalize on investments.

However, with growing corporations and stock exchanges came an increase in corporate reporting, making it more feasible to track long-term investments based on rising share value. Moreover, for much of modern financial history dividends have been taxed at a higher rate than capital gains from stock sales. In the United States, however, dividends and long-term capital gains are taxed at the same rate—0%, 15% or 20%—depending on total income. 

Tax Differential is a Long-Term Difference

Despite the equitable tax rate, dividends are taxed every year while capital gains are not taxed until the stock is sold. That time factor means the equity investment increases tax-free and thus grows exponentially faster. Thus, proponents of equity over dividends say the tax preference still holds. Moreover, they argue that companies assuming a tax differential viewpoint are focused on share appreciation and thus often have more funds available for growth and expansion than companies focused merely on increasing their dividends. In turn, that growth increases share value.

A counter argument is that dividend payouts are a sure thing while company growth is unpredictable. This is the so-called "bird in the hand" argument. Proponents of this viewpoint also note that dividend payouts can actually increase a company's share value, because the dividends themselves are attractive to investors seeking regular income. Finally, a third argument is that dividends have no bearing on stock value. Despite decades of study, the question of dividends versus equity remains unresolved.