The Tax Disadvantage of Dividends
Taxes are an important market imperfection that influences a firm’s decision to pay dividends or
repurchase shares.
Taxes on Dividends and Capital Gains
Shareholders typically must pay taxes on the dividends they receive. They must also pay capital gains
taxes when they sell their shares. When a firm pays a dividend, shareholders are taxed according to the
dividend tax rate. If shareholders sell shares to create a homemade dividend, the homemade dividend
will be taxed according to the capital gains tax rate. If dividends are taxed at a higher rate than capital
gains, which has been true until the most recent change to the tax code, shareholders will prefer share
repurchases to dividends. The higher tax rate on dividends also makes it undesirable for a firm to raise
funds to pay a dividend.
Optimal dividend Policy with Taxes
The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no
dividends at all.
The trend away from dividends has noticeably reversed, however, since the 2003 reduction in the
dividend tax rate (taxes for dividends and gains equalized). While dividends accounted for more than
80% of corporate payouts until the early 1980s, the importance of share repurchases grew dramatically
in the mid-1980s after the SEC gave guidelines that provided firms a “safe harbour” from accusations
of stock-price manipulation.
While this evidence is indicative of the growing importance of share repurchases as a part of firms’
payout policies, it also shows that dividends still remain a key form of payouts to shareholders. The
fact that firms continue to issue dividends despite their tax disadvantage is often referred to as the
dividend puzzle.