Dividend Income Tax Incentives and the Cost of Equity Capital
Asian Tax Journal Vol. 21 No. 2 (2020), pp. 93-125
Abstract
This study investigates whether dividend income tax incentives affect the implied cost of equity capital of high－dividend companies and whether these effects depend on the ownership structure of the companies. We also analyze whether companies that increased dividends for tax benefits maintain high dividends without these tax benefits. For empirical tests, we use ex ante measures of the cost of equity capital as a dependent variable and identify high－dividend companies following tax law. Our main results are as follows. First, the cost of equity capital of high－dividend firms decreases during the period of tax incentives. This indicates that investors lower the required rate of returns by reflecting the reduced tax burdens, which supports the dividend tax capitalization hypothesis. Second, the higher the ownership of the largest shareholders, the less the effect of the dividend tax capitalization. This result suggests that high dividend decisions for the tax benefits of the largest shareholders are negatively evaluated in the capital market or that the dividend tax capitalization is mitigated because the tax benefits of the largest shareholders are reduced due to the 2016 revision of tax law. We also find that companies with high profitability can afford to increase their dividends for tax benefits and maintain increased dividends, which is consistent with the purpose of the tax incentives. In the case of low－profitability companies, dividends are temporarily increased in order to receive tax benefits, and there is a possibility that these excessive dividends lower the capacity to invest. This study suggests that the temporary tax benefits affect the cost of equity capital of high－dividend companies, and that this effect depends on the ownership structure and profitability of the companies. These results imply that the policy makers need to closely consider the ownership structure and profitability of companies when they intend to encourage firms to increase dividends through tax benefits.
Keywords
- dividend income tax incentives
- implied cost of equity capital
- high dividend firm
- ownership of the largest shareholder
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