Tax preference theory
 Tax preference theory
Tax preference theory is one of the major theories concerning dividend policy in an entreprise. It was first developed by Litzenberger and Ramaswamy. This theory claims that investors prefer lower payout companies for tax reasons.
Litzenberger and Ramaswamy based this theory on observation of American stock market. They presented three major reasons why investors might prefer lower payout comapnies.
Firstly, unlike dividend, long-term capital gains allow the investor to deffer tax payment until they decide to sell the stock. Because of time value effects, tax paid immediately has a higher effective capital cost than the same tax paid in the future.
Secondly, up until 1986 all dividend and only 40 percent of capital gains were taxed. At a taxation rate of 50%, this gives us a 50% tax rate on dividends and (0,4)(0,5) = 20% on long-term capital gains. Therefore, investors might want the companies to retain their earnings in order to avoid higher taxes. As of 1989 dividend and capital gains tax rates are equal but defferal issue still remains.
Finally, if a stockholder dies, no capital gains tax is collected at all. Those who inherit the stocks can sell them on the death day at their base costs and avoid capital gains tax payment.
- Eugene F. Brigham, Louis C. Gapenski, Intermediate financial management, The Dryden Press 1990, p. 423-424
- Eugene F. Brigham, Fundamentals of financial management, The Dryden Press, 1992,p. 499-500
Author: Michał Pilarczyk