CORPORATE DIVIDEND POLICY RESPONSE TO THE TAX-REFORM ACT OF 1986

The tax implications of dividend policy on a firm's equity value conti nues to be a controversial issue in corporate finance. Although some s tudies indicate that taxes only weakly affect corporate managers' divi dend policy decisions, other evidence suggests that investors react to dividend payouts in line with their effective taxation on dividend in come and capital gains. The Tax Reform Act (TRA) of 1986, which lowere d the top marginal tax rates for ordinary income and equalized the sta tutory tax rates for dividends and capital gains, provided an unique o pportunity to investigate whether and how managers change dividend pol icy in response to significant tax changes: If the taxation of dividen ds and capital gains matters, the changes in the TRA suggest that corp orations should increase their dividend payout ratios, except possibly in the case of those firms with already high payout ratios that attra ct corporate investors whose taxation of dividends increased in the po st-TRA period. On the contrary, no systematic changes of dividend payo ut policies should be expected if corporate managers disregard tax fac tors, are unsure of the effective (as opposed to die statutory) margin al tax rates of their shareholders, or consider other factors like the information or signaling effects of dividend payouts. Examining, ther efore, whether corporations changed their payout policies in accordanc e with tax-based predictions of dividend policy can provide evidence o n the influence of taxes on corporate dividend policy decisions. We ex amined changes in dividend payouts for a sample of 283 firms drawn fro m the FORTUNE500 and FORTUNE50 lists of industrial and utility firms f or which the relevant data from the 3rd quarter of 1983 to the 1st qua rter of 1991 were available. For the aggregate samples of the industri al and utility firms, we found positive changes in payout ratios, but tests of statistical significance on the mean differences of payout ra tios failed to reject the null hypothesis of zero mean difference in t he dividend payout ratios before and after the TRA. However, when we c lassified the industrial firms into five quintiles according to their payout ratios in the pre-TRA period, we found strong evidence of signi ficant dividend payout ratio changes. Specifically, the mean differenc es of payout ratios were positive and significantly different from zer o for firms in the first three quintiles (low to medium payout ratio) and negative and significantly different from zero for firms in quinti le 5 (very high payout ratio). Of the 49 firms in each of the quintile s 1, 2 and 3, 73, 71 and 61 percent, respectively, had positive payout ratio changes, whereas only 21 percent of the 48 firms in quintile 5 had positive changes. These findings suggest that firms with low to me dium payout ratios, which attract ordinary investors with high effecti ve marginal tax rates, increased their dividend payout ratios since di vidends would be taxed less in the post-TRA period. On the contrary, f irms with very high payout ratios, which attract corporate investors w ith low effective marginal tax rates for dividends, decreased their pa yout ratios since the taxation of dividends for such investors would b e slightly heavier in the post-TRA period. For additional evidence on the impact of tax changes on dividend policy, we examined whether the relationship of dividends to current earnings shifted in the post-TRA period. The Lintner model suggests that current dividends are determin ed by past dividends and current earnings. If the TRA increased (decre ased) the preference for dividends, then we should find a positive (ne gative) incremental adjustment of dividends to current earnings. Using industry groups, we found this prediction to be supported in seven of the 19 industry groups. Using firm-specific data, we found evidence o f significant incremental adjustment of dividends to current earnings in 23.2 percent of the 276 firms analyzed. We also found that the perc entage of firms with positive and significant incremental responses wa s higher for quintiles 1, 2 and 3 (low to medium payout ratios) and lo wer for quintiles 4, 5 and the utilities sample (high to very high pay out ratios). These findings are indicative of tax-induced changes in d ividend payout policies. The evidence from this study is suggestive of several important conclusions concerning corporate dividend policy de cisions. First, corporate dividend policies were changed following the tax reform of 1986. Second, firms changed their dividend policies in line with the preferences of their respective dividend clienteles. Bot h of these conclusions are important for managers who set dividend pol icy according to tax-clientele considerations. Third, not all firms wi thin each quintile experienced uniform changes in dividend policy. Thi s implies that factors other than taxes may have also influenced divid end policy.