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Tax Preference Theory

By Yuriy Smirnov Ph.D.

Definition

The tax preference theory of dividends was developed by Robert H. Litzenberger and Krishna Ramaswamy. This theory claims that dividend policy affects investor behavior due to the difference in taxation of dividends and capital gains. The study was based on an analysis of the U.S. stock market, and the authors determined that investors prefer companies paying low dividends or not paying them at all since the amount of taxes payable is minimized.

Assumptions

The tax preference theory may be applied if the following assumptions are met:

  1. The capital gains tax rate is higher or equal to the dividend tax rate. If this assumption is true, investors will prefer to buy stocks of companies that do not pay any dividends at all. Thus , they can maximize their cash flows.
  2. The capital gains tax has to be paid at the moment when capital gains are actually realized. Investors can decide when capital gains will be realized, i.e., when to sell their stock. By contrast, dividend payouts depend on company management, and investors are not able to affect it.
  3. If an investor dies, the heirs will not pay a capital gains tax. In other words, the heirs may sell inherited stock and avoid a capital gains tax.

Breaking down the tax preference theory

As mentioned above, the tax preference theory of dividends assumes that the capital gains tax rate is lower than the dividend tax rate. Thus, investors prefer to buy stock with lower or even a zero dividend payout. Other things being equal, the required rate of return for investors with high payout stock will be higher to compensate for greater tax expense. It follows that a corporation with higher dividend payouts will have a higher cost of equity and therefore the cost of capital than corporations with lower payouts.

Tax preference theory of dividend policy

Moreover, other things being equal, the value of a corporation with lower dividend payouts is higher than one with higher dividend payouts.

Proof of the tax preference theory is also shown by the time value of money. We can state that the present value of $1 of dividend tax expected to be paid in a year is higher than the present value of $1 of capital gains tax expected to be paid in three years. In other words, investors are interested in paying taxes as late as possible. This argument explains investor preference for capital gains rather than dividends.