J Econ Finan

DOI 10.1007/s12197-009-9101-7

The interaction of corporate dividend policy and capital

structure decisions under differential tax regimes
Ufuk Ince & James E. Owers

# Springer Science + Business Media, LLC 2009

Abstract We develop a valuation model that integrates corporate capital structure

and dividend payout policies. The resulting extended Miller (J Financ 32:261297,
1977) model explicitly incorporates the different tax rates on corporate income,
personal interest, dividends, and capital gains. We apply the model to ten different
U.S. tax regimes since 1979 and generate several testable predictions. When the
dividend tax rate exceeds the capital gains tax rate, dividend payout can partially
offset value-enhancing effects of leverage. When the two rates are close, dividend
payout loses its moderating influence. Using the S&P 1500 universe, we obtain
empirical results that are consistent with the models predictions.
Keywords Capital Structure . Dividend Policy . Tax Rates
JEL Classification G32 . G35 . H24 . H25

1 Introduction
Almost half a century after the seminal MM contributions (Modigliani and Miller
1958; Miller and Modigliani 1961), capital structure and dividend policy continue to
The paper benefited greatly from detailed insights and comments generously provided by the late Franco
Modigliani. Comments by an anonymous reviewer improved the paper significantly. We gratefully
acknowledge input by colleagues and research support from University of Washington, Bothell and
Georgia State University, Robinson College of Business. Karel Vandromme and Leng Ling provided
excellent research assistance. The usual disclaimer applies.
U. Ince (*)
Business Administration, University of Washington, Bothell, 18115 Campus Way NE, Bothell,
WA 98011, USA
e-mail: ince.ufuk@gmail.com
J. E. Owers
Robinson College of Business, Georgia State University, Atlanta, GA 30303, USA

J Econ Finan

be topics of great interest in the academic literature and for industry practitioners. In
this paper we aim to contribute to the understanding of capital structure, dividend
policy, and their interaction. We develop a model in which firm value is determined
simultaneously by dividend payout and financial leverage. The model explicitly
accommodates four different income tax rates: corporate income, personal interest,
cash dividends, and capital gains. We apply the model to ten different U.S. tax
regimes since 1979 and generate several testable predictions. Two key findings relate
to the effect of tax rate differentials on the relationship between dividend payout,
financial leverage, and firm value. When the dividend tax rate exceeds the capital
gains tax rate, dividend payout can partially offset value-enhancing effects of
leverage. When the two rates are close, dividend payout loses its moderating
influence. Using the S&P 1500 universe, we obtain empirical results that are
consistent with the models predictions.
Table 1 shows that, there has been a significant variation in the tax rates over the
past three decades. Under the tax code that was in effect until 2003, the personal tax
rates applicable to interest and dividend income streams were essentially identical. In
contrast, the marginal tax rates for dividend and capital gains portions of the equity
income were typically significantly different. Recognizing this divergence, in our
model we partition the income on equity into its two components, to which distinctly
different tax rates apply. This enables the derivation of an extended Miller model
that incorporates the effects of both leverage and dividend payout under one unified
analytical framework. In particular, we obtain an equation that adds a third term
(dividend payout) to the Miller (1977) expression. Examining the model and its
comparative statics, we observe that dividend payout is an important factor in
determining firm value above and beyond the effect of leverage. In the Modigliani
and Miller (1958, 1963) and Miller (1977) models, which do not formally
incorporate the dividend payout and focus only on leverage, the valuation effect of
leverage is typically positive. However, when dividend payout is allowed to play a
role, the value effect of leverage is not as straightforward. The tax rates on different
income streams and their relative values determine the exact nature of the influence
of dividend payout on firm value.
Using our model, we then investigate how varying tax regimes during the period
from 1979 to 2002 affected firm value and their implications for dividend policy and
capital structure decisions. In particular, during the late 1980s and early 1990s, when
all four tax rates were within a few percentage points of each other, the effect of
payout is negligible. However, when the spread between capital gains and dividend
tax rates becomes significant (such as in periods I and III in Fig. 1), the dividend
payout term is influential in moderating, and at times even reversing, the positive
effect of leverage.
To reveal whether the intuition and predictions gleaned from the analysis of the
three-term model are consistent with the evidence, we conduct an empirical analysis
using companies in the S&P 1500 index. We find that the influence of the payout
ratio was strongest in periods I and III when dividend and capital gains tax rates
were far apart, and much weaker in period II when they were similar, confirming the
predictions of the model.
The main contribution of this study is the development of a concise model that
reveals the conditions under which dividend policy is irrelevant (as in Miller and

J Econ Finan
Table 1 Tax regimes between 1979 and 2008. Maximum applicable personal, corporate and capital gains
tax rates over the course of eleven distinct tax environments are provided in the table. Column pi lists the
marginal personal tax rates on interest income, column pd lists the marginal personal tax rates on dividend
income, column c lists the marginal corporate income tax rate, and column pg the marginal tax rate on
capital gains. For most of the three decades examined in this study pi and pd were identical. The name of
the tax legislation that governs a particular tax regime is provided below the table
Year(s)

Personal tax rate on

interest income pi

Personal tax rate on

dividend income pd

Personal tax rate

on capital gains pg

Corporate
income tax
rate c

19791981

70.0%

28.0%

46.0%

19821986a

50.0%

20.0%

46.0%

1987b

38.5%

28.0%

40.0%

19881990b

28.0%

28.0%

34.0%

19911992c

31.0%

28.9%

34.0%

19931994d

39.6%

28.9%

35.0%

19941997d

39.6%

29.2%

35.0%

19982000e

39.6%

21.2%

35.0%

2001f

39.1%

21.2%

35.0%

2002f

38.6%

21.2%

35.0%

15.0%

35.0%

20032008
a

35.0%

15.0%

Economic Recovery Tax Act of 1981

Tax Reform Act of 1986

Omnibus Budget Reconciliation Act of 1990

Omnibus Budget Reconciliation Act of 1993

Taxpayer Relief Act of 1997

Economic Growth and Tax Relief Reconciliation Act 2001 (EGTRRA)

The Jobs and Growth Tax Relief Reconciliation Act 2003 (JGTRRA)

Modigliani 1961), or on the contrary, is an important factor to consider. Recent

studies have provided strong evidence for the relevance of dividends. DeAngelo and
DeAngelo (2006) reexamine the Miller and Modigliani (1961) result and conclude
that, contrary to that celebrated result, dividends are not irrelevant. Similarly,
Auerbach and Hassett (2006, 2007) study the wealth effects of various key events
that led to the enactment of the Jobs and Growth Tax Relief Reconciliation Act of
2003 (JGTRRA), and show that the level of dividend payout is an important
determinant of the change in firm value.
Except the five-year period during 19881992, dividend and capital gains income
streams were historically taxed at significantly different rates. Our model implies that
during those years when there was a tax bias in favor of capital gains, dividend
policy did have valuation implications. Under the provisions of JGTRRA, the rate
difference between the two types of equity income streams converged in 2003 for
the first time after 11 years. As a result of this convergence, our model indicates that
firm values are once again payout-insensitive. As of August 2009, the U.S. Congress
has not yet acted to extend the JGTRRA dividend taxation provisions. Therefore, it
is probable that in 2010 the sunset provisions of JGTRRA will take effect and the tax
rates will revert back to those during the pre-2003 regime. Dividend policy will once

J Econ Finan
80%

70%

Tpipi
Tcc

pd
pi

pg
Tpg
pd
Tpd

Top Marginal Tax Rate

60%

50%

c
c
pi

40%

30%

pg

pg
pd

20%

10%

Period I

Period II

Period III

JGTRRA
2008

2003
2004
2005
2006
2007

2001
2002

2000

1996
1997
1998
1999

1994
1995

1992
1993

1990
1991

1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989

0%

Fig. 1 Top marginal tax rates over the last three decades. The figure depicts the variation in the marginal
federal tax rates applicable to four types of income: personal tax rate on interest, pi; personal tax rate on
dividends, pd; personal tax rate on capital gains, pg; and corporate income tax rate, c. The four tax rates
varied significantly during the three decades from 1979 to 2008, both in absolute levels and in relation to
each other. Period II from 1988 to 1992 stands out in terms of the narrow band within which all four rates
fell. Periods I and III are characterized by rates that were spread over a wider numerical range, with all
Period III rates (except pg) at significantly lower levels than those during Period I. The personal tax rate
on dividend income declined the most, from 70% to 15%, erasing the tax advantage for capital gains
income by 2003. The historically low tax rates during the period from 2003 to 2008 are prescribed by the
Jobs and Growth Tax Relief Reconciliation Act (JGTRR). This period is characterized by only two tax rate
levels, where the marginal tax rates on corporate and personal income both are 35% and the personal tax
rates on dividends and capital gains are both 15%

again interact with financial leverage to affect firm value. Given the wide historical
variation in the tax rates on the two types of equity income streams, measuring the
moderating influence of dividend payout policy on the leverage/firm value
relationship is especially important.

2 Literature review
Since Modigliani and Miller addressed the capital structure decision (Modigliani and
Miller 1958) and the dividend payout policy (Miller and Modigliani 1961) of a firm in
a deterministic framework, the literature in these two areas has grown substantially.
The original irrelevance propositions based on the arbitrage arguments were shortly
followed by a revision based on the corporate tax deductibility of interest payments
(Modigliani and Miller 1963). The recognition of the impact of taxation on optimal
capital structure continued with the 1976 American Finance Association presidential
address of Merton Miller (1977). His model employed three different tax ratescorporate, personal on debt income, and personal on equity income. Using a capital

J Econ Finan

market equilibrium argument, Miller generated a result that once again made capital
structure irrelevant for firm value. The Miller model that is now in every corporate
finance text book along with the MM Propositions I and II, is as follows1:



1
t c 1
t s
VL VU 1

D
1
1
t d
After this contribution, the literature evolved in several directions, in which one or
more of the original MM assumptions were relaxed to establish the relevance of
leverage. During this phase, bankruptcy costs have been frequently included as a
factor in determining optimal capital structure. Agency theory (Jensen and Meckling
1976; Jensen 1986), asymmetric information (Myers and Majluf 1984), and product
market based relevance arguments (Harris and Raviv 1991) emerged in the capital
structure literature over the ensuing years. Studies that rely on purely tax-based
theories became less common with the exception of a significant contribution by
DeAngelo and Masulis (1980), which demonstrates the existence of an interior
optimum for the capital structure decision. Unlike the previous work that found an
interior optimum, DeAngelo and Masulis (1980) did not rely on bankruptcy or
agency costs. Their optimum solution rests on the explicit modeling of the non-debt
tax shields such as depreciation expenses and investment tax credits. Haugen and
Senbet (1986) provide a review of the literature on the role of taxes for corporate
finance decisions.
The increased focus in more recent work on non-tax based models does not mean
that taxes as determinants of capital structure and dividend policy are any less
important today. The significant advances in game and information theory during the
last three decades created substantial opportunities for addressing the financing and
investment policies of the firm. Within the context of these contributions and several
significant changes in the tax code (particularly the JGTRRA), it is time to
reexamine tax-based theories.
In the three decades since the publication of the Miller (1977) model, the U.S. tax
code underwent extensive revisions. There have been several significantly different
tax regimes both in terms of the level of tax rates and other special provisions such
as dividend tax-shields. Several studies have addressed the implications and
applicability of the Miller and other tax-based models in response to evolving tax
regimes. Miller and Scholes (1978) point out the ability to almost completely shelter
dividend proceeds under the Tax Reform Act of 1976. This sheltering provision
justifies the use of one tax rate,s, in the Miller model on income from equity both in
the form of dividends and capital gains. Tax Reform Act of 1986 eliminated the
ability to shelter dividends (Chang and Rhee 1990), making the distinction between
the tax rates on dividends and capital gains relevant. Graham (1996) explores the
relation between leverage and marginal tax rates, and argues that the relative levels
of the three tax rates in the Miller model can influence the choice between equity and
debt financing. He simulates marginal tax rates that are consistent with the U.S. tax
code, and shows a positive association between tax status and incremental debt
policy. Graham and Tucker (2006) show that firms rely on non-debt tax shields
extensively to shelter corporate income. Their analysis indicates that the size of the
1

c: Corporate tax rate; s: Personal tax rate on equity income; d: Personal tax rate on interest income.

J Econ Finan

tax shelters average 9% of firms asset values on average. As predicted by DeAngelo

and Masulis (1980), firms that engage in tax sheltering on average rely on debt
financing less.
As the capital structure and dividend payout policies were under intense examination
in the academic literature, there was an ongoing persistent decline in dividend payments
by firms during the same period. Historically disappearing dividends were studied in
detail by Fama and French (2001) with a focus on dividend payouts from 1972 until
1999. Among the firms trading on the NYSE, AMEX, and NASDAQ, the percentage
of firms paying cash dividends declined from 66.5% in 1978 to 20.8% in 1999. The
authors note that to some extent this trend is explained by the characteristics of such
firms, as more public firms assume the traditional non-divided paying firm profile.
Denis and Osobov (2008) also investigate dividend policy in several developed
countries and generally observe similar trends. They find that this seemingly
international phenomenon is not explained by the changing composition of traded
firms, or by the catering explanation. They conclude that the evidence is consistent
with an agency explanation of dividend policy.
DeAngelo et al. (2004) provide significant additional insights into the trends in
dividend policy, and emphasize the concentration of such payments in a relatively
small number of firms in what they refer to as a two-tier structure. DeAngelo et al.
(2006) test a life-cycle theory of dividend policy evolution and find that firms with a
high level of earned versus contributed capital are much more likely to pay high
dividends. DeAngelo and DeAngelo (2006) challenge the notion of dividend policy
irrelevance in the original Miller and Modigliani (1961) model and provide rationale
for the relevance of dividend policy. Their conclusions are compatible with the
implications of our model in that dividends are relevant for the firm value, although
the direction of the causation is not fully consistent with our model.

3 The analysis with three different investor income tax rates

In this section, we derive the gain from financial leverage with the explicit
recognition of differential tax treatment of income to investors from three sources:
interest, dividends, and capital gains. The resulting expression is similar to the Miller
(1977) model (Eq. (1)); however, it also incorporates the value effect of dividend
policy along with that of firms leverage. In parallel with Millers approach, we
assume that the tax rates that apply for personal income from dividends, interest, and
capital gains are uniform at the highest marginal rates applicable at the time.
Similarly, the tax rate that applies for corporate income is uniform across all firms.
We also assume that earnings before interest and taxes (X) exceed the interest
payments (rD) on the firms outstanding debt (D). Under these assumptions, the total
periodic cash flow (Y) to shareholders and lenders of the firm can be expressed as:




Y X
rD1
t c 1
t ps rD 1
t pi

where pi is the personal tax rate on interest income, ps is the personal tax rate on
equity income both in the form of dividends and capital gains, and c is the corporate
tax rate. Assuming a dividend payout ratio of and recognizing the first term on the

J Econ Finan

right hand side in Eq. (2) as the sum of the dividend and the capital gains income
streams, taxable at pd and pg respectively, we have:




Y p X
rD1
t c 1
t pd 1
p X
rD1
t c 1
t pg


3
rD 1
t pi :
After rearranging Eq. (3) we obtain2:

"

#




1
t c 1
t pg


Y X 1
t c 1
t pg rD 1
t pi 1

1
t pi



p X
rD1
t c t pd
t pg :

Equation (4) has three components that can be interpreted individually. The first term
represents the after-tax cash flow of an all-equity non-dividend-paying firm to its
shareholders. The middle term is the cash flow consequence of the leverage D. The
last term is the cash flow consequence of the payout policy .
By assuming that the value of a levered and dividend-paying firm is the present
value of the perpetuity with periodic cash flows Y, and therefore capitalizing the
individual terms of Y at appropriate discount rates applicable for the particular
riskiness of each cash flow stream (s for the last term)3:
"

VL; V0L;0


#

1
t c 1
t pg
p X
rD1
t c 


1

t pd
t pg 5
D

rs
1
t pi

where:
VL,
V0L,0

Value of the leveraged and dividend-paying firm

Value of an all-equity firm with zero dividend payout.

The first two terms on the right-hand-side of Eq. (5) correspond to the Miller
model. The last term is the value consequence of the payout policy and can be
interpreted as the present value of all future dividends multiplied by the tax rate
differential of personal dividend income and capital gains. Therefore,
"

VL; V0L;0


#





1
t c 1
t pg
future


1

D
PV
t pd
t pg :
dividends
1
t pi

The extended model above reduces to the Miller model when any one of the
following three conditions holds:
(a.) The payout ratio () is zero: Even though Miller (1977) does not make any
explicit assumption regarding dividends, his model appears to implicitly
assume zero dividend payout.
2

See the Appendix for the intermediate steps.

Note that the after-tax perpetual interest payments discounted by the required rate of return for the
riskiness of the firm debt equals the market value of the debt D. The assumptions necessary for this
derivation are the same as those in the original MM analyses.

J Econ Finan

(b.) The tax differential (pdpg) is zero: Historically, until the passage of the
JGTRRA, this differential has mostly been positive. It declined from 42%
during 19791981 to 0% during 19881990. The differential grew to more
than 10% between 1993 and 2002, and is again zero under the 20032008 tax
regime (JGTRRA). Even during those years when the two marginal tax rates
are numerically equal, capital gains are effectively taxed at a lower rate than
dividends. This is due to investors ability to postpone the payment of the
capital gains tax until the gain is realized.
(c.) The earnings before interest and taxes equal the interest expense (X=rD): For a
firm this would be a distressing and hopefully infrequent occurrence, which
could not be sustained in the long run.
Out of the three scenarios above that reduce our model to Miller (1977), the
second one is the most relevant one for this study. It implies that the extent to
which the dividend payout has an impact on the firms optimal capital structure
depends on the tax differential between capital gains and dividends. We explore
the numerical and empirical implications of this tax differential in the remainder
of the paper.
Even though it is a possible undertaking, a capital market equilibrium condition
similar to the one developed in Miller (1977) is not pursued in this paper. Such
equilibrium in our setting would presumably imply irrelevance for both capital
structure and dividend payout policies for the marginal investor. However, empirical
relevance of leverage is well established and just as industry-specific debt ratios
exist, there also exist industry specific dividend payout ratios. The electric utility
industry, for example, is characterized by payout ratios that remained high
persistently over time. Therefore, our focus here is not to prove irrelevance, but to
use our model to provide insights into the nature of the relevance of dividend payout
ratios, leverage, and the interaction of the two under differential tax regimes.

4 The interaction of capital structure and dividend policy

4.1 Comparative statics
The gain from leverage and the loss from payout implied by the results derived in
the previous section are:
"

#

1
t c 1
t pg
p X
rD1
t c 


VL;
V0L;0 1

t pd
t pg
D

rs
1
t pi
7
The independent effect of leverage, as measured by D, on this gain can be
expressed for a given dividend payout by the following partial derivative:
@
prT
1
P
@D
rs

J Econ Finan

where for notational convenience tax-rate variables are expressed collectively as P=

(1c)(1pg)/(1pi) and T=(1c)(pdpg). Similarly, for a given level of leverage,
the effect of the dividend payout policy is:
@
X
rDT


@p
rs

In Eq. (8) the valuation effect of leverage is linear and positive in the payout ratio
(except when the tax differential is zero or negative). This implies that the gain from
leverage is more pronounced for a firm with a higher payout ratio. The nature of this
moderating effect of the dividend payout is also directly related to the tax rate
differential (pdpg). As the differential shrinks, so does the effect of the payout
ratio on the gain from leverage. When the differential is zero, as it was during the
late 1980s and is today under the JGTRRA, the moderating effect of the payout ratio
disappears. Accordingly, during tax regimes when the differential is large, one could
expect to find firms with high payout ratios to also carry higher leverage and vice
versa. This is a prediction implied by our model that we empirically test in Section 5.
Another notable implication of Eq. (8) emerges when P>1. Under that situation,
the Miller model would only detect the negative effect of increased leverage, caused
by substantially higher personal income tax rate compared to corporate and capital
gains tax rates. In contrast, in our extended model, there could still be a gain from
leverage if the last term in Eq. (8) is sufficiently large, either due to a large tax rate
differential or a high dividend payout ratio.
Equation (9) can be similarly analyzed. For a given level of leverage, increasing
the dividend payout almost always (except when the tax differential is zero)
decreases the firm value. It is true that stockholders are taxed at the same rate on
their dividend income as bondholders are on their interest income. However, tax
deductibility applies only for interest payments, and therefore for the firm, dividends
are costlier than interest payments. This effect disappears when the tax differential is
zero since it is then equally costly for the shareholders to realize capital gains income
and receive dividend income. This indifference makes the payout decision irrelevant.
4.2 Numerical analysis
Figure 2 demonstrates the implications of the derived model for ten different
historical tax regimes. Firm values are normalized with respect to the firm with zero
debt and zero dividend payout.4 The panels in the figure indicate that the combined
net impact of corporate dividend and capital structure policies on firm value is
directly affected by the pertinent tax rates at the time.
We next discuss the implications of the model for dividend and capital structure
policies under several historical tax regimes. Three representative tax regimes
(19791981, 19881990, 19932002) were chosen for analysis out of the ten that
were in existence at some time during the three decades since 1979. The three
4

We assume a symbolic value of $1.00 for a non-dividend-paying all-equity firm. The gain from leverage
and loss from payout emerge as a percentage of this $1.00 baseline value as a function of the four tax
rates.

J Econ Finan
1979-81

1982-86

1.60

1.60

1.40

1.40

1.20

1.20

= 0%

1.00

0.80

0.60

0.60

= 100%

20%

40%

60%

0.60
0.40
0.20

Debt Ratio
0%

100%

20%

40%

1988-90

60%

80%

100%

0.00
0%

1.60

1.40

1.40

= 0%

1.40

= 0%

0.80

0.80

0.60

0.60

0.60

0.40

0.40

0.40

0.20

0.20

40%

60%

100%

1.00

Debt Ratio
0.00

0%

20%

40%

60%

80%

100%

0%

1.00

1.00

= 100%

0.80

0.80

0.60

0.60

0.60

0.40

0.40

0.40

0.20

0.20

40%

60%

0.20

0%

100%

= 100%

Debt Ratio

Debt Ratio

0.00
80%

100%

= 0%

1.20

0.80

20%

80%

1.40

= 0%

1.20

Debt Ratio

60%

2001

1.40

= 100%

40%

1.60

= 0%

1.20

0.00
0%

20%

1998-2000
1.60

1.00

= 100%

0.20

0.00

1994-97
1.60
1.40

= 0%

Debt Ratio
80%

100%

1.20

1.00

20%

80%

= 100%

0.80

Debt Ratio

60%

1.60

1.20

= 100%

40%

1993-94

1.00

0.00
0%

Debt Ratio
20%

1991-92

1.60

1.20

0.80

= 100%

0.00

80%

= 100%

1.00

0.20

Debt Ratio

= 0%

1.20

0.40

0.20
0.00
0%

1.40

= 0%

1.00

0.80

0.40

1987
1.60

20%

40%

60%

80%

100%

0.00
0%

20%

40%

60%

80%

100%

2002
1.60
1.40

= 0%

1.20
1.00

=100%

0.80
0.60
0.40
0.20

Debt Ratio

0.00
0%

20%

40%

60%

80%

100%

Fig. 2 Normalized firm value (VD,/V0,0) as a function of leverage and dividend payout for ten different
tax rate regimes over the interval 19792002. VD, is the value of a firm with the indicated debt ratio (DR)
and dividend payout ratio (DPO) . V0,0 is the value of an unlevered firm with a zero payout ratio. DR is
calculated using COMPUSTAT industrial data files as (Notes payable + Long term debt)/(Market value of
equity + Notes payable + Long term debt) and DPO is the dividend per share divided by the earnings per
share (DPS/EPS). Each panel contains the normalized firm value as a function of the debt ratio and
dividend payout ratio under the corresponding tax rates

J Econ Finan

representative tax regimes exhibit distinctly different set of tax rates both in terms of
absolute values and relative to each other. For this reason, these three contrasting
regimes provide a suitable setting to test the value implications of our model. If our
model provides a reasonable representation of firms capital structure and dividend
policy decisions, the three contrasting tax regimes would be the ideal environment to
observe the fit between the models predictions and the empirical observations.
4.2.1 Years 19791981
The application of the model using the tax rates from the period 19791981 reveals a
subtle effect, visible in Table 2A and Fig. 3. The table and the figure depict
normalized firm value, VD,/V0,0, as a function of the leverage D and the dividend
payout . The gain from leverage is positive only when the firm is at a relatively
high payout ratio (above approximately 40%), with the maximum gain occurring at
full (100%) payout. Interestingly, at a dividend payout level lower than 40%,
increasing leverage lowers firm value.
The reversal of the leverage effect at lower payout ratios is driven by the relative
levels of tax rates. During the years 19791981, the top marginal tax rate for
personal income was very high in comparison to the tax rate for corporate income
(70% and 46% respectively). In a tax rate environment such as this, high taxes paid
by the bondholders for their interest income proceeds exceed the benefit from the tax
deductibility of interest payments at the firm level. Since debt financing can be
assumed to have zero NPV, this additional burden is borne by the shareholders. At
high levels of dividend payout on the other hand, the taxation of the dividend
income makes dividend payout even more disadvantageous compared to paying
interest. In other words, now it would be more beneficial for the firm to borrow and
pay interest rather than dividends. The benefit reaped from the tax deductibility of
interest payments tilts the balance in favor of debt financing, and makes leverage
more attractive. Figure 3 depicts this reversal of the loss from leverage with
increasing payout ratio for the years 19791981.
Another noteworthy observation about the 19791981 tax rate environment is the
steep loss in firm value at very low debt levels in response to increasing dividend
payout (see Figs. 2 and 3). According to our model, it was possible for an all-equity
firm to experience losses in value up to 58% (i.e., VD,/V0,0 values ranging from
1.00 to 0.42 in the first column of Table 2A). The firm could mitigate this loss by
maintaining a higher debt level.
The tax regime that made the interesting features discussed above possible is not a
short-term anomaly confined to the years 19791981. Indeed, the entire period
between the Great Depression and the late 1970s was characterized by a similar tax
rate environment. Our model indicates that optimal policies to maximize firm value
under such tax regimes required zero debt and zero dividend payout. This
prescription interestingly comports with the observed leverage policies of the time,
when numerous prominent companies such as IBM and Coca Cola had little, if any,
debt before the 1980s. However, if a firm would need to maintain high dividend
payout levels, it would be better off by carrying a relatively high debt level at the
same time. Traditional electric utility companies are examples that appear to fit this
mold.

J Econ Finan
Table 2 Normalized firm value (VD,/V0,0) as a function of leverage and dividend payout for three tax
regimes. VD, is the value of a firm with the indicated debt ratio (DR) and dividend payout ratio (DPO) .
V0,0 is the value of an unlevered non-dividend paying firm. DR is calculated using COMPUSTAT
industrial data files as (Notes payable + Long term debt)/(Market value of equity + Notes payable + Long
term debt) and the dividend payout ratio is the dividend per share divided by the earnings per share (DPS/
EPS). Each row contains the normalized firm value as a function of the debt level at a particular payout
ratio. (For a visual representation of the data in Panels A, B, and, C refer to Figs. 3, 4, and 5 respectively)
Debt ratio
0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

(A) 19791981: Normalized firm value VD,/V0,0

Dividend payout ratio

0%

1.00

0.98

0.95

0.93

0.91

0.89

0.86

0.84

0.82

0.79

0.77

10%

0.94

0.92

0.91

0.89

0.87

0.86

0.84

0.82

0.81

0.79

0.77

20%

0.88

0.87

0.86

0.85

0.84

0.83

0.82

0.81

0.79

0.78

0.77

30%

0.83

0.82

0.81

0.81

0.80

0.80

0.79

0.79

0.78

0.78

0.77

40%

0.77

0.77

0.77

0.77

0.77

0.77

0.77

0.77

0.77

0.77

0.77

50%

0.71

0.71

0.72

0.73

0.73

0.74

0.75

0.75

0.76

0.77

0.77

60%

0.65

0.66

0.67

0.69

0.70

0.71

0.72

0.74

0.75

0.76

0.77

70%

0.59

0.61

0.63

0.65

0.66

0.68

0.70

0.72

0.74

0.75

0.77

80%

0.53

0.56

0.58

0.60

0.63

0.65

0.68

0.70

0.72

0.75

0.77

90%

0.48

0.50

0.53

0.56

0.59

0.62

0.65

0.68

0.71

0.74

0.77

100%

0.42

0.45

0.49

0.52

0.56

0.59

0.63

0.67

0.70

0.74

0.77

(B) 19931994: Normalized firm value VD,/V0,0

Dividend payout ratio

0%

1.00

1.03

1.06

1.09

1.12

1.15

1.18

1.21

1.25

1.28

1.31

10%

0.98

1.02

1.05

1.08

1.11

1.15

1.18

1.21

1.24

1.27

1.31

20%

0.97

1.00

1.04

1.07

1.10

1.14

1.17

1.21

1.24

1.27

1.31

30%

0.95

0.99

1.03

1.06

1.10

1.13

1.17

1.20

1.24

1.27

1.31

40%

0.94

0.98

1.01

1.05

1.09

1.12

1.16

1.20

1.23

1.27

1.31

50%

0.92

0.96

1.00

1.04

1.08

1.12

1.15

1.19

1.23

1.27

1.31

60%

0.91

0.95

0.99

1.03

1.07

1.11

1.15

1.19

1.23

1.27

1.31

70%

0.89

0.94

0.98

1.02

1.06

1.10

1.14

1.18

1.22

1.27

1.31

80%

0.88

0.92

0.97

1.01

1.05

1.09

1.14

1.18

1.22

1.26

1.31

90%

0.86

0.91

0.95

1.00

1.04

1.09

1.13

1.17

1.22

1.26

1.31

100%

0.85

0.90

0.94

0.99

1.03

1.08

1.12

1.17

1.22

1.26

1.31

(C) 2002: Normalized firm value VD,/V0,0

Dividend payout ratio

0%

1.00

1.02

1.04

1.06

1.08

1.10

1.12

1.14

1.16

1.18

1.20

10%

0.98

1.00

1.02

1.04

1.07

1.09

1.11

1.13

1.15

1.18

1.20

20%

0.96

0.98

1.00

1.03

1.05

1.08

1.10

1.13

1.15

1.17

1.20

30%

0.93

0.96

0.99

1.01

1.04

1.07

1.09

1.12

1.15

1.17

1.20

40%

0.91

0.94

0.97

1.00

1.03

1.06

1.08

1.11

1.14

1.17

1.20

50%

0.89

0.92

0.95

0.98

1.01

1.04

1.08

1.11

1.14

1.17

1.20

60%

0.87

0.90

0.93

0.97

1.00

1.03

1.07

1.10

1.13

1.17

1.20

70%

0.85

0.88

0.92

0.95

0.99

1.02

1.06

1.09

1.13

1.16

1.20

80%

0.82

0.86

0.90

0.94

0.97

1.01

1.05

1.09

1.12

1.16

1.20

90%

0.80

0.84

0.88

0.92

0.96

1.00

1.04

1.08

1.12

1.16

1.20

100%

0.78

0.82

0.86

0.91

0.95

0.99

1.03

1.07

1.11

1.16

1.20

J Econ Finan

1979-81
V(D,) / V(0,0)
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
0%
20%
40%
60%
P/O Ratio
80%

0%
100%

b
V(D,) / V(0,0)

90%
60%
30%

V(D,) / V(0,0)

1979-81

1.60

1.60

1.40

1.40

1.20

Debt Ratio
(D)

1979-81

1.20

= 0%

D=0%

1.00

1.00

0.80

0.80

D=100%
0.60

0.60

=100%

0.40

0.40

0.20

0.20

D=0%

Debt Ratio
0.00
0%

D=100%

20%

40%

60%

80%

100%

0.00
0%

P/O Ratio()
20%

40%

60%

80%

100%

Fig. 3 a Normalized firm value (VD,/V0,0) surface as a function of leverage and dividend payout: 1979
1981. The surface is not a flat plane because of the interactive nature of the valuation model under the tax
rates pertaining during this time period. VD, is the value of a firm with the indicated debt ratio (DR) and
dividend payout ratio (DPO) . V0,0 is the value of an unlevered firm with a zero payout ratio. DR is
calculated using COMPUSTAT industrial data files as (Notes payable + Long term debt)/(Market value of
equity + Notes payable + Long term debt) and DPO is the dividend per share divided by the earnings per
share (DPS/EPS). b Normalized firm value (VD,/V0,0) as a function of debt ratio (left) and dividend
payout ratio (right). VD, is the value of a firm with the indicated debt ratio (DR) and dividend payout
ratio . V0,0 is the value of an unlevered firm with a zero payout ratio. At any debt ratio less than 100%,
dividend payout reduces firm value. On the other hand, at payout ratios less than 40%, leverage reduces
firm value

4.2.2 Years 19881990 (and 19911992)

The situation during the years 19881990 is unique because during that time the top
marginal tax rates on ordinary income (thus on dividend and interest income) were
nominally the same as the tax rate on capital gains at 28%. In the following 2 years
(19911992), the two tax rates remained very close (at 31.0% and 28.9%
respectively). The result of the convergence in tax rates is visible in Fig. 2 for the

J Econ Finan

19881990 and 19911992 panels. There is little if any moderating influence of the
dividend payout on the leverage-firm value relation. The maximum theoretical gain
from leverage is close to 50% regardless of the level of dividend payout. As
discussed and anticipated in Section 4.1 on the comparative statics for our model, the
influence of the dividend payout ratio vanishes due to the near-zero tax rate
differential (pdpg) during the years 19881992.
4.2.3 Years 19932002
In contrast to the reversal effect observed under the tax regime during 197981, and
similar to the situation during 19881992, the gain from leverage is always positive
under the 19932002 tax regimes. The details of the gain from leverage relation and
the effect of the dividend payout for the years 19931994 and the year 2002 are
available in Figs. 4 and 5, and Table 2B and 2C. As a departure from the previous
tax regimes discussed above, throughout this decade-long time interval, the gain
from leverage is significantly more pronounced for high payout firms. Although at
low or zero debt levels increased dividend payout reduces the firm value, the
negative impact of the dividend payout weakens as the debt level increases. This
effect is clearly visible in the left panels of Figs. 4b and 5b.
In contrast to the maximum potential gain from leverage during 19881992 that
reached up to 50%, the tax rate changes throughout the 1990s (see Table 1)
significantly reduced the maximum potential gain. Figure 2 indicates that in 1993,
the maximum potential gain was near 30%, and by 1998, approximately 20%,
remaining at that level through 2002.
4.3 Summary and empirical implications
The nature of the combined impact of financial leverage and dividend policy on firm
value over the years 19792002 is found to be wide ranging as a direct result of the tax
rate changes. We discussed above three distinct tax regime environments in detail. In
the first interval 19791981, low leverage and low dividend payout leads to higher firm
value. However, given a high dividend payout, the firm is better off by carrying a high
debt level. That suggests a simultaneous increase or decrease in leverage and payout
for firms. It is less likely to find firms with low leverage and high payout (which results
in the minimum possible firm value). The empirical implication of the model for the
19791981 time interval is a positive association between leverage and payout.
The same logic applies throughout the years following the 19791981 time
interval up to 1987 and again after 1992. During the years 19791987, the tax rates
were such that at low debt levels, firm value declined with increasing dividend
payout ratios. Similarly, from 1993 until 2002, firms would suffer losses in value if
they chose to increase dividend payout while maintaining low debt levels. In
contrast, during the 19881992 time interval, there was no penalty for having a high
dividend payout for a firm with a low debt level. Dividend payout was truly
irrelevant during that time and would not be expected to systematically vary between
firms that carry various levels of debt.
The breakdown in the interaction of dividend payout and capital structure during
the 19881992 time period as implied by our model provides an opportunity to test

J Econ Finan

1993-94

V(D,) / V(0,0)
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
0%
20%
40%
60%
P/O Ratio
80%

0%
100%

1993-94

V(D,) / V(0,0)

30%

(D)

1993-94

V(D,) / V(0,0)
1.60

1.60
1.40

90%
60% Debt Ratio

D=0%
1.40

= 0%

1.20

1.20

1.00

1.00

= 100%

0.80

0.80

0.60

0.60

0.40

0.40

D=100%

0.20

0.20

Debt Ratio
0.00
0%

20%

40%

60%

P/O Ratio()
80%

100%

0.00
0%

20%

40%

60%

80%

100%

Fig. 4 a Normalized firm value (VD,/V0,0) surface as a function of leverage and dividend payout: 1993
94. VD, is the value of a firm with the indicated debt ratio (DR) and dividend payout ratio (DPO) . V0,0
is the value of an unlevered firm with a zero payout ratio. DR is calculated using COMPUSTAT industrial
data files as (Notes payable + Long term debt)/(Market value of equity + Notes payable + Long term debt)
and DPO is the dividend per share divided by the earnings per share (DPS/EPS). b Normalized firm value
as a function of leverage (left) and dividend payout (right). The lower left panel highlights the increase in
the slope (gain from leverage) and it is also presented in Fig. 2 along with the corresponding panels from
each of the other tax regime periods

the model empirically. If our model is a reasonable representation of the dividend

payout-capital structure interaction under varying tax rate environments, we would
expect a positive association between dividend payout and debt levels during the
years 19791987 and 19932002 (Period I and III in Fig. 1). During the years 1988
1992 (Period II in Fig. 1), the association between dividend payout and leverage is
expected to be weaker. We conduct several empirical tests in Section 5 to examine
the validity of these predictions.
It is worth noting that, to the extent firms have shifted their distributions to their
shareholders from dividends to stock repurchases over time, our empirical analysis,
which only uses dividend payout data, will not be able to pick up this trend. Indeed,

J Econ Finan

2002

V(D,) / V(0,0)

1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
0%
20%
40%
60%
P/O Ratio
80%

0%
100%

2002

V(D,) / V(0,0)

90%
60% Debt Ratio
30%

(D)

2002

V(D,) / V(0,0)
1.60

1.60

1.40

1.40

D= 100%

= 0%

1.20

1.20
1.00

1.00

= 100%

0.80

0.80

D= 0%

0.60

0.60

0.40

0.40
0.20

0.20

Debt Ratio

0.00
0%

20%

40%

60%

80%

100%

0.00
0%

P/O Ratio()
20%

40%

60%

80%

100%

Fig. 5 a Normalized firm value surface as a function of leverage and dividend payout: 2002. VD, is the
value of a firm with the indicated debt ratio (DR) and dividend payout ratio (DPO) . V0,0 is the value of
an unlevered firm with a zero payout ratio. DR is calculated using COMPUSTAT industrial data files as
(Notes payable + Long term debt)/(Market value of equity + Notes payable + Long term debt) and DPO is
the dividend per share divided by the earnings per share (DPS/EPS). b Normalized firm value as a
function of leverage (left) and dividend payout (right)

during the three decades under study there was a shift in firms attitudes toward share
repurchases vis--vis dividend payout. We do not pursue stock repurchases empirically
in this study due to data limitations. However, note that the model derived in this paper
is implicitly capturing the valuation effect of repurchases via the capital gains term.

5 Empirical analysis and results

We use a sample of 1,500 firms that make up the S&P 1500 Composite Index and
represent roughly 75% of the total stock market capitalization in the U.S. We retrieve
annual financial statement data from COMPUSTAT Industrial Files for the S&P

J Econ Finan

1500 firms and use the data to examine the validity of the empirical predictions for
the model developed earlier in the paper.
Using the ten panels depicted in Fig. 2, the various different tax rate environments
in the last three decades are categorized into three generally distinct regimes (Fig. 1):
(I)

The 19791987 era, when the double taxation of dividend income coupled
with the relatively steep personal and corporate tax rates led to significant firm
value sensitivity to dividend payout rates especially at low levels of debt;
(II) The 19881992 period when the near parity between the ordinary income
(from dividends and interest) and capital gains tax rates almost completely
eliminated the firm value sensitivity to payout rates; and
(III) 19932002 during which the sensitivity of firm value to payout rates
reemerged due to the widening gap between ordinary income and capital
gains tax rates at the personal level.

During the periods I and III, the negative effect of the dividend payout on the firm
value interacts with the positive effect of leverage. During those years, we expect
high payout firms to be levered more than low payout firms. When the dividend
payout is at a low level or even zero, the gain from leverage is less pronounced than
when the firm exhibits a high payout level.5 However, during the middle period (i.e.,
19881992), very low or non-existing sensitivity of the firm value to dividend
payout substantially reduces the interaction between leverage and payout. The gain
from leverage is almost identical at all possible payout levels. The two financial
policies are substantially detached from each other in relation to firm value.
It is a well-established observation that during the entire time period 19792002 firms
on average have consistently reduced their dividend payouts (see Fig. 6). According to
our model, the gain from leverage is the highest for a firm with a 100% dividend
payout ratio (DPO). When DPO declines, as it did significantly during the last three
decades, we would expect the leverage (DR) of firms to also decline in tandem with the
decline in dividends. This is especially true for period I, where for low payout firms the
gain from leverage is negative and also for period III, where there was a significantly
higher gain from leverage for high payout firms compared to low payout firms. The
data in Fig. 6 and Table 3, Panel A on the historical trends of DPO and DR confirm this
prediction. Debt ratio (DR) is calculated using COMPUSTAT Industrial Files as (Notes
payable + Long term debt)/(Market value of equity + Notes payable + Long term debt).
DPO is dividend per share dividend by earning per share (DPS/EPS). We observe both
ratios declining from 3035% to 1520% over the 24-year period. This observation is
in line with the models prediction of a close association between DPO and DR.
To assess the association between DPO and DR further, we measure the correlation
between the two time series (Table 3, Panel B). Over the 24-year period the correlation
between DPO and DR is strong at 81.1%. However, the correlation is significantly
lower at 51.9%, when measured over period II only. When we exclude period II, the
correlation between the two variables is 81.9%. The correlations measured during
distinctly different tax rate environments are in support of the earlier prediction that
DR and DPO should be closely related in periods I and III and not related in period II.
5

The slopes of the sides of the wedges in Fig. 2 are smaller for the low payout firms (toward the higher
side) than for high payout firms (toward the lower side).

J Econ Finan
40%

40%

Debt ratio
Dividend
payout ratio

Pe riod II

35%

35%

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

15%
1985

15%
1984

20%

1983

20%

1982

25%

1981

25%

1980

30%

1979

30%

Fig. 6 The general decline in the debt ratio (DR) and dividend payout (DPO) between 1979 and 2002.
Period II is the five-year span during which the dividend and capital gains tax rates were essentially the
same. Annual financial data from COMPUSTAT Industrial Files for the S&P 1500 firms are employed.
The S&P 1500 consists of the S&P 500 large-cap, S&P 400 mid-cap and S&P 600 small-cap companies,
in total representing approximately 75% of the U.S. stock market capitalization. DR is calculated using
COMPUSTAT Industrial Files as (Notes payable + Long term debt)/(Market value of equity + Notes
payable + Long term debt). DPO is dividend per share dividend by earning per share (DPS/EPS)

To understand whether the correlation results above are driven by annual sample
averages only or are actually the result of the characteristics of a large number of
firms, we also compute the correlations between DPO and DR within each of the
24 years. As seen in Fig. 7, the two ratios are positively correlated within each year
during the entire study period. In line with our expectations, the correlations drop
noticeably during the middle period when our model predicts a disassociation
between leverage and payout. From around 2530%, the correlations drop down to
as low as 6%, after which they reach back up to the 2530% range.
Finally, we examine one of the key predictions of the model developed earlier in
the paper: Firms with higher dividend payout ratios will carry more debt compared
to firms with lower payout ratios. We expect this to be the case particularly during
periods I and III, when our valuation model under the particular tax rates at the time
assigns lower values to low-debt firms that pay large dividends. During period II,
dividend payout has no effect on firm value and is therefore expected to have no
systematic relation to leverage.
For each year, we divide the sample equally into high DPO and low DPO firms.
Figure 8 indicates that on average high DPO firms have higher debt levels during the
entire time period. The relation is stronger in periods before and after the disconnect
interval 19881992 and somewhat weaker in that middle interval. Whereas the
differential is around 15%20% over the earlier and later periods, it declines to 5
10% during the disconnect period of 19881992. All differences are statistically
significant at the 0.001 level, except in 1993 (a transition year) when the significance
declines to 0.01.

J Econ Finan
Table 3 Sample statistics and correlations: 19792002. The sample consists of S&P 1500 index members
as of 2002. The debt ratio (DR) is calculated using COMPUSTAT industrial data files as (Notes payable +
Long term debt)/(Market value of equity + Notes payable + Long term debt) and the dividend payout ratio
is the dividend per share divided by the earnings per share (DPS/EPS). We exclude from the sample those
firms for which one or more pieces of data are missing on COMPUSTAT in a particular year. Panel A
reports average values for DR and DPO, and number of firms in the sample for each year from 1979 to
2002. Panel B reports the correlations between DR and DPO for three sub-periods of interest. The subperiod 19881992 is Period II during which ordinary income (on dividends and interest) and capital gains
tax rates were the same (19881990) or very close (19911992). Our model predicts a disconnect between
DR and DPO during Period II, which is confirmed by the much lower correlation during Period II in
comparison to the correlation during the other periods
(A) Average leverage and dividend payout
Year

Debt Ratio(DR)

Dividend Payout Ratio (DPO)

1979

562

34.5%

32.1%

1980

573

33.5%

34.7%

1981

608

32.2%

35.0%

1982

600

31.7%

36.3%

1983

631

26.6%

33.7%

1984

670

27.3%

32.1%

1985

697

26.1%

31.7%

1986

721

24.5%

29.3%

1987

770

24.6%

29.4%

1988

792

27.7%

26.2%

1989

798

27.0%

29.0%

1990

821

28.3%

31.2%

1991

863

25.3%

29.3%

1992

924

22.8%

26.1%

1993

1,001

20.1%

25.6%

1994

1,075

20.6%

26.6%

1995

1,124

20.4%

24.0%

1996

1,182

18.7%

22.9%

1997

1,217

17.8%

21.8%

1998

1,246

19.4%

21.5%

1999

1,316

21.9%

22.5%

2000

1,347

22.6%

19.3%

2001

1364

21.6%

19.4%

2002

1,405

22.2%

17.6%

28.7%

31.7%

Average
(B) Correlations: DR and DPS
Years (Periods)

Correlation

19792002 (Periods I,II,III)

81.1%

19881992 (Period II)

51.9%

19791987 & 19932002 (Periods I,III)

81.9%

J Econ Finan
0.35

0.30
Period II
0.25

0.20

0.15

0.10

0.05

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

0.00

Fig. 7 Annual correlations of debt ratio and payout between 1979 and 2002. Correlations for all firms
within each year are calculated. Period II is the five-year span during which the dividend and capital gains
tax rates were essentially the same. As expected, the level of correlations drops markedly during Period II.
Annual financial data from COMPUSTAT Industrial Files for the S&P 1500 firms are employed. The S&P
1500 consists of the S&P 500 large-cap, S&P 400 mid-cap and S&P 600 small-cap companies, in total
representing approximately 75% of the U.S. stock market capitalization. DR is calculated using
COMPUSTAT Industrial Files as (Notes payable + Long term debt)/(Market value of equity + Notes
payable + Long term debt). DPO is dividend per share dividend by earning per share (DPS/EPS)

In summary, our basic empirical analysis confirms the general predictions of the
model. The empirical analysis is conducted within a static framework, in which we
examine the financial policies of the firm in response to the then current set of tax rates.
Another avenue for empirical testing could take a more dynamic approach. This would
involve looking at the changes in the tax regimes and how firms adjust their leverage and
dividend policies in response to these changes over time. In the next section we discuss
the empirical implications of the model when subjected to such tests in a dynamic setting.

6 Other empirical implications of the model

There are several empirical implications of the model related to earlier research on
corporate security exchanges, trends in corporate dividend payout practices, and the
impact of major new tax legislation, such as JGTRRA, on equity prices. Although
empirically exploring those implications is beyond the scope of this paper, below we
briefly explore them.
6.1 Security exchange implications
The implications of security exchanges have been extensively tested in papers such
as Masulis (1980) and Rogers and Owers (1985). These studies typically did not
control for dividend payout ratios and it is apparent from the model in this paper that

J Econ Finan
70%

DR for high DPO firms

19%

DR for low DPO firms

DR Difference (all years significant > 1%)

60%

Period II

14%

40%

9%

30%
4%

DR Difference

Debt ratio (DR)

50%

20%
-1 %
10%

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

-6 %
1979

0%

Fig. 8 Comparison of financial leverage (DR) between high and low dividend payout (DPO) firms in
each year: 19792002. Period II is the five-year span during which the dividend and capital gains tax rates
were essentially the same. As expected high DPO firms have higher DRs than low DPO firms with the
differences much higher outside the Period II. All differences are significant at the 1% level or higher. DR
Difference (right scale) is the absolute difference of Debt Ratio (DR, left scale) between high and low
dividend payout (DPO) firms. Annual financial data from COMPUSTAT Industrial Files for the S&P 1500
firms are employed. The S&P 1500 consists of the S&P 500 large-cap, S&P 400 mid-cap and S&P 600
small-cap companies, in total representing approximately 75% of the U.S. stock market capitalization. DR
is calculated using COMPUSTAT Industrial Files as (Notes payable + Long term debt)/(Market value of
equity + Notes payable + Long term debt). DPO is dividend per share dividend by earning per share
(DPS/EPS)

dividend policy might have an impact on the extent of abnormal returns associated
with security exchanges (whether they be equity-for-debt or debt-for-equity).
6.2 Dividend policy trends and changes
The recent examination of trends in dividend policy following Fama and Frenchs
Disappearing Dividends paper in 2001 has produced an insightful series of studies,
some of which were discussed previously in the literature review. Papers such as
DeAngelo and DeAngelo (2006), DeAngelo et al. (2004), and DeAngelo et al.
(2006) are important examples of the evolving of literature in this topic.
Additionally, the survey by Brav et al. (2005) and the catering study of Li and Lie
(2006) provide additional insights into dividend policy.
Figure 2 in this paper indicates that for eight of the ten tax regimes examined,
increasing dividend payout ratio decreases the value of the dividend-paying firm
regardless of its leverage. However the intensity of the effect varies markedly as
visually indicated by the width of the band between zero payout and high payout
firms. There is the potential to empirically examine the relation between the rate of

J Econ Finan

dividend policy changes and the valuation consequences. For example, Fig. 2
suggests that the rate of decline in dividends during the years 19791981 might have
been more rapid than the rate of decline during the years 19881990. Examination of
issues such as this while controlling for leverage at the firm level could enable us to
better understand shifts in dividend policy over the past three decades. Just as
DeAngelo et al. (2006) noted that dividend policy is affected by the earned/
contributed capital, it could also be affected by the change in the debt ratio in line
with the prescriptions of the model in this paper.
6.3 Effect of the JGTRRA on firm values
Several studies have examined the abnormal returns for various categories of firms
during the resolution of uncertainty associated with the enactment of the legislation.
In one such study, Auerbach and Hassett (2007) investigate the differential effects of
JGTRRA for mature firms, the subset of mature firms more likely to have
subsequent share issues, and immature firms that had never paid a dividend. Our
model suggests that other explanatory factors (which are possibly correlated with
their sample partition) could be the level of leverage and pre-existing payout ratio.
In a related study, Auerbach and Hassett (2006) examine the impact of uncertainty
associated with the 2004 presidential election (as measured using the political futures
market data from the Iowa Electronic Markets) on the option values associated with
the categories of firms identified above. Again, incorporating the insights of the
model in this paper could help to further partition the universe of firms for a more
targeted empirical analysis.
Howton and Howton (2006) examine whether the 2003 reduction in the dividend
tax rate led to higher dividends. They do not find significant changes in overall
measures such as average dividend yields and average payout ratios. However, they
show an increase in the rate of change, with firms paying out more dividends and
acceleration in the rate of dividend initiations. They conclude that the probability of
increasing dividends in 2003 and 2004 was directly related to free cash flow and the
potential for value signaling through dividends (page 70). Again, the insights
generated in our paper could be used in reexamining the questions raised in studies
of tax legislation such as Howton and Howton (2006).

7 Conclusion
In this paper we develop a valuation model that ties together capital structure and
dividend payout polices while incorporating differential tax rates on dividend
distributions and capital gains. As such it is an extension of the original Miller and
Modigliani (1961) dividend policy model and of the Miller (1977) model. We
numerically and graphically demonstrate the implications of this new model under
ten different tax regimes in effect since 1979 and derive the implications of the
model for firm value as a function of debt ratio and dividend payout ratio.
Our analysis indicates a wide range of firm values depending on the particular set
of tax rates applicable at the time. In the first interval, 19791981, when the tax
regime featured a high rate on dividend income in comparison to the rates on

J Econ Finan

corporate income and personal capital gains, increasing financial leverage would
lead to losses in firm value, if the dividend payout was relatively small. At dividend
payout ratios below 40%, the loss in firm value in response to increased debt ratio
could potentially reach 23%. During the same time period, if the firm maintained a
dividend payout ratio in excess of 40%, the firm value could almost double, if an allequity firm decided to take on debt. During the 19881990 time period, when the tax
rates on dividend income and capital gains were both 28%, an all-equity firm
(without regard to its dividend payout level) could increase in value by as much as
50% as it took on more debt. Under the tax regimes prevailing after 1998, the
maximum potential gain for a non-dividend paying all-equity firm was roughly 20%,
whereas a firm with a high dividend payout could be worth 50% more if it were to
boost its debt financing.
Using the analysis of the valuation model under a diverse set of tax regimes, we
develop several predictions for empirical testing. The results of the empirical tests
are strongly supportive of the basic predictions of our analysis in a static setting. The
interaction between dividend policy and financial leverage decisions is significantly
influenced by the prevailing tax rates. The more dynamic predictions of the model
remain for subsequent examination.
By design, our tax-based model abstracts from the well-known and important
contributions of previous studies on bankruptcy/financial distress costs, agency
considerations, and signaling theories. However, the insights gained from our
extended tax-based model could contribute in a significant way to the understanding
of corporate financial policy in both research and policy dimensions. It is a wellestablished notion within the trade-off theory of corporate capital structure that a
range of debt levels exists, in which debt financing has a positive impact on firm
value. Over this range, our model has the potential to provide a valuable insight into
the effect of dividend policy on capital structure.
In the near future, another major change in the U.S. tax environment is possible,
especially if the JGTRRA is allowed to expire by the Congress. The ability of the
model in this paper to easily incorporate the new levels of marginal tax rates on four
types of income makes it a useful tool for corporate decision makers in analyzing
dividend and debt decisions. For purposes of research, the model can be used to gain
insights into the evolution of dividend policy over the past three decades.

Appendix




Y p X
rD1
t c 1
t pd 1
p X
rD1
t c 1
t pg


rD 1
t pi

A1

By cross-multiplying the middle term,





p X
rD1
t c 1
t pd X
rD1
t c 1
t pg
p X
rD1
t c




1
t pg rD 1
t pi

J Econ Finan

and combining the first and the third terms of the new expression, we have






p X
rD1
t c t pg
t pd X
rD1
t c 1
t pg rD 1
t pi :
Now, by taking the rD term from the second term and combining it with the third
term,




p X
rD1
t c t pg
t pd X 1
t c 1
t pg




rD 1
t pi
1
t c 1
t pg


and by taking 1
t pi outside of the third term and rearranging,
"

#




1
t c 1
t pg


Y X 1
t c 1
t pg rD 1
t pi 1

1
t pi



p X
rD1
t c t pd
t pg :
A2

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