Impact of Taxation on Dividends

Impact of revenue enhancement on Dividends rescindThis research paper attempts to analyze the polar value strategy of ruless and their electrical shock on the dividend distributions. It is explained that the dividend payout is mo nononic anyy distributed across judge regimes as the firms in twin valuateation (classical) body return significantly lower payouts than companies in the uncomplete-imputation system, while companies in the abundant imputation system pay the highest payouts. Our results hold when the other fundamental determinants of dividends be held done Lintners model and the actual payout balance. Overall, it is reported that the type of dividend levy system equal the dividend payout.IntroductionThe levy rouse on dividends depends on incorporate and personal income task systems. In a classical system, the total tax is the sum of the corporation tax, the effective dandy gains tax and the tax on dividends. Typically the tax on dividends exceeds the gains tax creating an incentive to reduce dividends. In an imputation system on the other hand, the total tax is given by the corporation tax plus the effective gains tax plus the decreased dividend tax. If the reduction in the tax on dividend is large enough to drive reduced tax dividend lower than the effective large(p) gains tax, an incentive to subjoin dividends is created.Understanding the impact of taxes on dividend policy is important for both faculty memberians and practitioners. From academic perspective, the relevance of taxation will highlight the extent to which companies consider the after tax return of their sh arholders and how any tax reform will affect the firms dividend payouts. For practitioners, knowing how taxation affects dividends is also of considerable interest. Since shareholders are taxed diversely, if gestate prices reflect the tax status of one particular class of investors, other groups can take advantage of these differences by, namely trading nearly the ex-dividend dates to capture/ avoid dividends. Moreover, understanding the impact of dividend taxation will be important for fund managers and analysts as changes in tax codes could affect the terminate returns and the relative pricing of securities.Most countries around the world adopt different systems of taxing dividends. well-nigh follow a classical tax system where corporate income is treated differently from personal income in terms of statutory tax rate and deduction rules, others use some level of consolidation between corporate and personal income. The important distinction between these dickens different systems is the taxation of dividends. Countries that follow the classical system separate shareholders income from the income of their corporations. As a result the same social building block of earning in the company is taxed twice when it is paid as dividend first at the corporate level and indeed at the personal level a disadvantage known as two-ba ser taxation?. In contrast, countries that follow a more unified system usually declare a lavish or partial relieve from dividend tax in consideration of the fact that the same unit of earning has been taxed at the corporate level. In Pakistan, the system of double taxation (classical system) is utilise i.e. the dividends are taxed on corporate level and because the same unit of earning is taxed at shareholder level.BackgroundMore than forty years ago, milling machine and Modigliani (1961) showed that, after some assumptions, such as complete and perfect capital markets, a firms dividend policy does not affect its value. piece this possibleness has highlighted the five main factors that could affect dividends, namely signalling, agency costs, behavioral (catering and mental accounting) and taxation, the empirical turn up provided to-date on such effects is mixed, (Allen and Michaely (2006) and graham flour (2003). In particular, while in theory taxation is anticipate to delay companies from paying dividends, most previous empirical studies have shown that taxation plays a minor role in dividend decision (e.g. Brav et al., (2005), Fama and French (2001), Julio and Ikenberry (2005). Therefore it is not clear why companies still pay dividends despite their heavy tax burden. In this paper, the dividend tax systems is analyzed and test the hypotheses that, in countries where the tax burden on dividends is high, companies pay low dividends.Although dividends may have a tax disadvantage, previous studies show that shareholders react positively to dividend increases and negatively to dividend decreases (e.g. Michealy, Thaley and Womack (1995). Long (1978) provides proof that in dual class shares, investors favor cash dividend over wrinkle dividend stocks. The tax disadvantage of dividends and yet their popularity challenges the traditional policy of payout policy. Blacks (1976) dividend puzzle discusses the weaknesses of the finance theory in answering t he simple question, why firms subject to a classical tax system to pay dividends? Some studies explain dividends away from taxes. For example Lintner (1956) in his classical study, shows that firms adopt a subjective target payout policy by decreasing dividends very late and hardly ever cut them. Models based on information imbalance suggest that dividend changes provide information about the firms hereafter cash flows (Bhattacharya (1979) and Miller and Rock (1985) or about the firms cost of capital and/or maturity stage (Grullon, Michaely and Swaminathon (2002), Grullon and Michaely (2000). From the agency theory perspective, dividends provide a disciplining tool to reduce agency costs (Easterbrook (1984) and Jensen (1986). behavioral finance theory suggests that dividends are paid in part to include certain biases in individuals such as market sentiment (Baker and Wurgler (2004) or self control, mental accounting and regret avoidance (Shefrin and Statman (1984). Taxation moe l suggests that if dividends are taxed at a higher rate than capital gains, firms should prefer to contain earnings or buy back shares (e.g. Auerbach (1979), Bradford (1981) , Auerbach and Hasset (2003), Lasfer (1996).Literature ReviewTo assess the impact of dividend tax on investment and financial policy of the firm, the literature has followed three basic glide slopees. The first approach is to examine the relation between the risk-adjusted pretax rate of return and dividend yield. If dividend tax is relevant and if dividends are taxed at a higher rate than capital gain, than pretax return should increase in counterpoise to dividend yield to compensate for dividend tax disadvantage. Black and Scholes (1974), Gordon and Bradford (1980), and Miller and Scholes (1982) did not take take the stand that the tax differential between dividends and capital gain have an impact on pretax returns, while Lintzenburger and Ramaswamy (1979) demote evidence to the contrary. The second appr oach is to examine the ex-dividend behavior of stock prices. Absent dividend tax, the value of a stock should fall by the full mensuration of the dividend on the ex-dividend day. Elton and Gruber (1970) provide evidence that US stock prices fall by less than the full amount of the dividends on the ex-dividend day. Poterba and Summers (1985) and Lasfer (1996) show similar results. Other studies did not find evidence that the tax differential between dividends and capital gains have an impact on the ex-dividend behavior, for example, Hearth and Rimbey (1993), Lakonishok and Vermaelen (1983). The third approach is to employ event study analysis. Changes in tax laws provide a natural experiment for investigating the impact of dividend tax on investment and financial decision. Poterba and Summers (1985) show that higher dividend tax is associated with lower investment and dividends. Poterba (2004) study shows that the tax disadvantage relative to capital gains has a negative effect on d ividend payment. Blouin et al. (2004) study the impact of the 2003 tax reduction in the US and find dramatic increase in the regular dividends and the special dividends after enactment and a decline in the share repurchases. Chetty and Saez (2004) report on increase in the fraction of dividend payers succeeding(a) the 2003 dividend tax reduction. In Pakistan the system of double taxation is implemented on dividends, its comparison with countries implying other system of taxations is studied.ObjectivesThe objectives of this research paper are to find out the impact of taxation on dividend policy and its impact on the financial and investment decision of the firms.Research QuestionIs the dividend payout ratio of firms in full or partial integration system higher than the dividend payout ratio of firms in double taxation system?Theoretical FrameworkDividend PayoutTaxation(Independent Variable)(Independent Variable) (Dependent Variable)HypothesesH1 Dividend payout ratio is higher in fu ll and partial integration systems than in classical system of taxation.H2 Dividend payout ratio is NOT higher in full and partial integration systems than in classical system of taxation.Hypotheses Testing contrary the full integration system, the classical system carries with it a disadvantage of double taxation. If tax on dividends has an impact on the financial policy of the firm, then firms in classical system will lower or avoid dividends as much as they can, while firms in full integration systems will not have to lower their dividends. Thus the hypothesis H1 is expected to be true.SystemNo. of Firm ObservationsNet Tax graze on Dividend (%)*Payout Ratio =DPS/EPS*Classical System1850%0.32partial tone1542%0.45Full1735%0.47* = Subject to 10% level of significanceResearch MethodologyPopulationPopulation includes observations that have been collected randomly from firms in 6 countries representing all the three types of taxation systems.SampleIt includes 50 observations, i.e. dat a has been collected randomly from 50 firms representing all the three taxation systems.Sources of Data CollectionThe annual OECD tax database incorporate and Individual Taxes, A Worldwide Summary, Price WaterhouseConclusionsThe dividend payout policy of companies was analyzed that applies different tax systems with regard to dividends. It is found that companies determined in countries that apply double taxation system (classical tax system) to have less dividend payout than do companies located in countries that try to partially avoid double taxation. In general, tax effect measured by the type of dividend tax treatment has a strong effect on the size of dividend payout.