Tax Preference Theory: Tax Preference Theory And Bird In Hand Theory

4.0 Tax Preference Theory
Tax preference theory and bird in hand theory are two main different theories with exactly different view on shareholder preference. According to Ehrhardt and Brigham(2008) tax reference theory states that shareholders prefer retain earning rather than pay as dividends. It is because taxes on dividends must be paid immediately once you received the dividends and most of the countries dividends tax rate higher than capital gain tax. However, taxes of capital gain can be deferred into future. Damodaran (1999) states that bird in hand theory implies that cash dividends are considered like a bird on hand but the retained earnings are like a bird in forest.
In short, tax preference theory believes that shareholder prefers
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With this data he found that decision of investor can be influenced by the tax treatment of capital gains and dividends. In contrast, Lewellen et al. (1978) found quite a weak supportive evidence of the clientele effect hypothesis by on the database used in studies of Petti(1977)
Besides that Eltoon and Gruber (1970) also show empirical evidence about the relationship between share price and ex-dividend day. However, what they found was that the stock price decrease and it is less than the amount of dividend on ex-dividend. Besides that, they also found that the relationship of stock’s dividend yield on ex-dividend equivalent size of its ex-dividend price decrease is positive. Therefore, they use this consequence as a proof that differential taxes made a preference for capital relative to cash dividends. Thus, they support the clientele hypothesis.
There is nothing wrong between views of bird in hand theory or tax preference theory. There just a conflict between these two concepts because in the real world, different countries have different tax rate on dividend and capital gain. There is an evidence can be supported by the research of Alliance company (Appendix) . After reviewing the data, it can be realised that there are three major types of countries. Firstly is the dividends tax rate higher than capital gain tax rate. Second is the capital gain tax rate higher than dividend tax rate. Lastly are countries without capital gain tax rate
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Auerbach and Hassett (2003) states that the dividends are taxed immediately if the dividend tax rate always higher that capital gain rate. It will result what the tax preference explanation suggest that a low level of dividend payout is preferable as to maximize the value and wealth of shareholder. A company will be more likely to use stock repurchases or otherwise retain earnings as a way to return corporate earnings to the shareholder.
Favorable treatment for capital gains over dividends would lead to an over-investment of firms financing new investment through retained earnings. This may be more heavily concentrated in certain sectors of the economy, thereby distorting the allocation of resources.
Accordingly, French has 44.0% of dividend tax rate which is significantly lower than 60.5% of capital gain tax rate. Based on research of McDonald, Jacquillat and Nussenbaum (1975), they stated that when dividends are taxed, companies are expected to defer them until the present value of payout taxes are zero, or opt for share buybacks that are subject to capital gains taxes if they are lower than the taxes on dividends. Besides that this concept also supported by DeAngelo et al (2008), Auerbach and Hassett (2003). Black (1976) concludes that corporations are the only investors with a tax preference for dividends, a view which is now widely

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