The purpose of this paper is to investigate the extent to which UK equity prices reflect shareholder level taxation on dividends (dividend tax capitalisation). Despite an extensive theoretical and empirical literature controversy exists.
Using a sample of UK firm year ends from 1991 to 2007 archival accounting and share price data are used to test for the presence or otherwise of dividend tax capitalisation.
The paper finds evidence of equity values reflecting shareholder level dividend taxation. In particular, a significant reduction in the valuation of retained earnings, a measure of dividend paying potential, is observed around the July 1997 abolition of the repayment of dividend tax credits to tax exempt shareholders. This suggests a link between shareholder level taxation of dividends and firms’ cost of capital.
The analysis focuses on share prices and is therefore subject to an underlying assumption of shareholders’ understanding tax and other potential relevant information.
The taxation of dividends is an important issue because of the potential for it to influence firms’ cost of capital and therefore investment decisions. Further, non-tax costs may be incurred to the extent that attempts are made to mitigate any “adverse” tax effects.
The results indicate that taxation of dividends and share prices are associated and therefore also indirectly firms’ cost of capital. This linkage has implications for investment appraisal and the allocation of capital between competing demands.
In using an asset valuation approach the limitations of alternate methods of examining shareholder level taxation of dividends are avoided, e.g. analysis of dividend drop of ratios.
The authors appreciate helpful comments from two referees and participants at Tax Research Network Annual Conference 2008, Galway, Ireland; British Accounting Association South West Region Conference, 2009; and University of Wales Accounting Colloquium 2010.
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