TAXATION AND CLIENTELE EFFECT OF DIVIDENDS

On the occasion when dividends and capital gains are differentially taxed, it becomes logical that equity investors would set themselves into heterogeneous classes, or ‘‘clientele,’’ by their effective tax brackets. In some countries, dividends are more tremendously taxed than capital gains, so investors with high tax debt tend to favour firms with lower dividend payout ratios, ceteris paribus. Investors subject to lower effective tax rates should behave in a complementary fashion and hence favour firms with higher payout ratios.

Differential taxation of dividends might impact equilibrium asset prices. Rational investors should be attracted only by after-tax returns, so it seems possible that firms with higher dividend payout ratios might have higher pre-tax expected returns, ceteris paribus (unless firms can arrange themselves in perfect correspondence with clientele. Whether or not it has an impact on asset pricing, dividend taxation represents a mystery with regard to the financial policy of corporations: if firms able to distribute cash through lower-taxed methods, for instance share repurchase, why are dividends ever paid?

Dividend clientele have been studied for couple decades. They are part of the asset pricing debate since heterogeneous clientele are implied by a dependence of expected returns on dividend taxes. The opposite is not true; clientele could still exist even with no asset pricing effect of taxation. For an investor to hold a stock over the ex-dividend date, the ex-dividend price decline must be less than the dividend by an amount that depends on the relative difference between the marginal effective dividend and capital gains tax rates. In purpose to try the presence of the clientele effect, two variables were hypothesized which should affect stockholder's desire to invest in a company. The first was the firm's dividend yield. The lower a firm's dividend yield the smaller the percentage of his total return that a stockholder expects to receive in the form of dividends and the larger the percentage he expects to receive in the form of capital gains. Therefore, investors who hold stocks which have high dividend yields should be in low tax brackets relative to stockholders who hold stocks with low dividend yields.

The second variable that we hypothesized might affect the ex-dividend behaviour of common stocks was the payout ratio. Firms that paid out a high percentage of their earnings as dividends would, all other things being equal, grow (both in terms of market price and earn-ings) at a slower rate than firms which retained a larger percentage of earnings. Thus, the high payout firm should attract stockholders in relatively lower tax brackets than the low payout firms.