Dissecting dividend decisions: some clues about the effects of dividend taxation from recent UK reforms

Abstract

We present empirical evidence which suggests that a big increase in dividend taxation for UK pension funds in July 1997 a¤ected the form in which some UK companies chose to make dividend payments, but otherwise had limited e¤ects on both the level of dividend payments and the level of investment. These …ndings are consistent with a version of the 'new view' of dividend taxation. We also identify a group of …rms whose dividend choices are di¢ cult to reconcile with (stock market) value maximisation.Acknowledgement: This paper is part of the research of the Large Business Tax Programme at the Institute for Fiscal Studies, supported by the Hundred Group, the Inland Revenue, and the ESRC Centre for Public Policy. We thank Alan Auerbach, Tim Besley, Roger Gordon, Jim Hines, Stephen Matthews, Jim Poterba, Joel Slemrod, David Ulph and participants in seminars at the ESRC Public Economics Working Group, IFS, IMF, the Inland Revenue, University of Manchester, University of Michigan, University College London and University of Warwick for helpful comments. Non-technical SummaryIn this paper we use data for a sample of 696 quoted non-financial UK companies to investigate empirically whether any changes in dividend or investment behaviour can be detected following the abolition of repayable dividend tax credits for UK pension providers in July 1997.This tax reform was intended to have a significant impact on the dividend decisions and investment spending of UK companies. More specifically, it was intended to reduce pressure from pension funds for UK firms to pay out a high share of their profits in the form of dividends, and thereby to allow firms to increase their investment spending.The tax treatment of dividends paid to UK pension funds before 1997 was certainly not neutral, and was unusual in that for these institutional investors there was a more favorable tax treatment of dividend income than capital gains. To what extent this affected company dividend decisions is far from clear, however, for two quite different reasons.First, given that some other investors (e.g. higher rate taxpayers) had a more favorable tax treatment of capital gains than dividends, while others (e.g. basic rate taxpayers and some foreign institutions) had no tax preference, the influence that UK pension funds could exercise over company dividend policies is uncertain.Second, even if UK pension funds were influential, it is unclear whether their tax preference for dividend income would affect dividend payments. That is, if other non-tax costs associated with issuing equity are sufficiently important that retained profits were still the cheapest source of finance for UK companies in the period before 1997, it is entirely possible that the abolition of repayable dividend tax credits for UK pension funds would have had no effect on the level of dividends. This is the prediction of a version of the so-called 'new view' of dividend taxation, which in essence says that if issuing equity is a more expensive source of finance than retaining profi...