F_9-21-07_LEROY-DivTax - USC FBE FINANCE SEMINAR presented...

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Dividend Policy and Income Taxation Stephen F. LeRoy University of California, Santa Barbara September 14, 2007 Abstract The e f ects of dividend and capital gains taxes on optimal dividend payout policy are analyzed in the context of a one-good model (so that capital consists of stored units of the consumption good). The aftertax discount factor is as- sumed to adjust to taxes to bring about equality between the discounted value of the rm’s aftertax dividend stream under the optimal dividend policy and the number of units of capital the rm is operating. A standard result–that the Miller-Modigliani dividend irrelevance proposition applies in the presence of taxes if the dividend tax rate equals the capital gains tax rate (and if capital gains are taxed as they accrue)–is demonstrated. The analysis is extended to deal with unequal tax rates. The two major results are (1) allocating retained earnings to share repurchases has the same tax implications as allocating re- tained earnings to new investments, and (2) either of these will be optimal if and only if the tax rate on capital gains is lower than that on dividends. JEL codes G1, G3. The Miller-Modigliani [9] dividend-irrelevance principle asserts (among other propo- sitions) that, in the absence of frictions, corporate dividend policy does not a f ect rm value. This is so because if investment is held constant, as Miller-Modigliani assumed, then by an identity a change in dividends is o f set one-for-one by a change in pro- ceeds from new security issues. Assuming that investors value rms by discounting payments to stockholders net of proceeds of new issues, rm value is una f ected by the dividends change. A related dividend-irrelevance proposition, often incorrectly attributed to Miller- Modigliani, applies if investment is not held constant: variations in future dividends do not a f ect rm value provided that retained earnings are invested in zero-net- present-value projects. This invariance is held to occur because the e f ect on rm value of a dividend increase is exactly o f set by lower future capital gains due to I am indebted to Alan Auerbach, Harry DeAngelo, Marek Kapicka, Oddgeir Ottesen and Yongli Zhang for discussions and correspondence on this material. 1 USC FBE FINANCE SEMINAR presented by Steve LeRoy FRIDAY , September 21 , 200 7 10:30 am – 12:00 pm, Room: JKP- 104
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lower retained earnings. Even in the absence of frictions, this dividend-irrelevance proposition is not correct without further restrictions, as has been pointed out by DeAngelo and DeAngelo [5], [6]. In the presence of frictions these results certainly fail, and there may exist a unique optimal dividend policy. Available results in this general case are much less complete than in the case where frictions are excluded. In this paper we analyze dividend policy in the presence of taxes on dividends and capital gains. The goal is to provide conclusions that are the counterpart for the case of positive taxes of the
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F_9-21-07_LEROY-DivTax - USC FBE FINANCE SEMINAR presented...

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