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What is a Tax Differential View of Dividend Policy?

The tax differential view of dividend policy is the idea that capital gains are better than dividends because the tax rate on capital gains is lower than the tax rate on dividends.

How Does a Tax Differential View of Dividend Policy Work?

For example, let's assume that the capital gains tax is 15% and the tax rate on dividends is 28%. This means that if John owns a share of Company XYZ that he originally bought for $10, his tax liability would look like this under two scenarios:

Scenario 1: Company XYZ stock rises by $1 to $11 per share. When he sells, John's capital gain is $1 and he must therefore pay $0.15 in taxes for the extra dollar of value he receives.

Scenario 2: Company XYZ decides to pay shareholders a $1 dividend. John must pay ordinary income tax of 28% on the $1, which works out to $0.28.

In both cases, John receives an extra dollar of value, but when that value comes in the form of dividends, the tax is much higher and John gets to keep less of it. As a result, John may be inclined to avoid dividend-paying stocks and focus on growth stocks instead (because they tend to produce capital gains instead of dividends).

Why Does a Tax Differential View of Dividend Policy Matter?

Every company has the responsibility to act in the best interests of its owners, the shareholders. That includes putting any leftover cash to its highest and best use. In some cases, the tax differential view of dividend policy is a reason for a company to adopt a growth strategy rather than a value strategy. In other words, they serve their shareholders' tax needs by plowing leftover cash back into capital expenditures and other ways to grow the company (and therefore the stock value) rather than giving leftover cash back to the shareholders in the form of dividends.

It is important to note, however, that the difference in capital gains tax rates and dividend tax rates is the key here. The larger the difference between the tax rates, the larger the incentive to trade one policy for the other.

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Paul Tracy
Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.