Are dividend taxes and tax imputation credits capitalized in share values

The relation between personal taxes and firm value has fundamental implications for understanding why firms pay dividends and how taxes influence capital structure choices. Assessing personal tax valuation effects also influences tax policy debates regarding the integration of corporate and personal taxes. Despite its importance, however, several underlying problems have hampered existing research on the valuation consequences of personal taxes, leading to mixed and inconclusive results. Cross-sectional approaches have proven difficult, for example, because variation in investor tax rates across firms is not generally observable. Using time-series variation in dividend tax rates alone to isolate the indirect effects of dividend taxes has been confounded by simultaneous changes in other tax parameters. In addition, a variety of questionable assumptions have confounded interpretation of relevant event studies. We address these problems by suggesting direct tests of the relationship between dividend taxes and share values. Retained earnings are subject to dividend taxes upon distribution, but paid-in equity can be returned to shareholders as a tax-free return of capital. Therefore we test the prediction that dividend taxes result in a lower value for retained earnings than for paid-in equity (after controlling for the influence of dividend taxes on the cost of using retained earnings capital). This focus on observable ratios of retained earnings to total common equity does not require use of unobservable investor tax rates. We strengthen this research design by repeating the basic test in several different tax regimes. In the United States, we perform tests for five tax regimes in the 1975-1994 period corresponding to five different levels of dividend taxation. We also conduct tests for the 19841994 period for Australia, France, Germany, Japan, and the United Kingdom. The non-U.S. settings allow for comparisons of empirical results across different levels of dividend tax relief provided by tax imputation credits. Our investigation results in three principal findings. First, firm-level results for the United States indicate that accumulated retained earnings are valued less per unit than contributed capital. This finding is consistent with the capitalization of future dividend taxes in retained earnings, and it is robust to inclusion of a variety of control variables and tests for possible alternative explanations. Second, we find that differences in dividend tax rates across U.S. tax regimes are associated with predictable differences in the implied tax discount for retained earnings. Third, cross-country variation in dividend tax rates is associated with predictable variation in the implied tax discount. Furthermore, the difference in dividend tax rates across two different tax regimes in the United Kingdom is associated with predictable differences in the value discount. Trevor S. Harris R. Glenn Hubbard Deen Kemsley Graduate School of Business Graduate School of Business Graduate School of Business Columbia University Columbia University Columbia University 610 Uris Hall 609 Uris Hall 607 Uris Hall New York, NY 10027 New York, NY 10027 New York, NY 10027 (212) 854-3495 (212) 854-3493 (212) 854-2641 tshl@columbia.edu rgh1@columbia.edu dkemsley@research.gsb. columbia.edu 1 This statement is true for a constant dividend tax; temporary changes in the dividend tax would affect payout decisions. 1