Adoption of Dividend Imputation System and Its Impact on the Degree of Financial Constraints of Firms– Evidence from Taiwan Stock Market
Chau-Chen Yang
NationalTaiwanUniversity
Cheng Few Lee
RutgersUniversity
Suming Lin
NationalTaiwanUniversity
Sheng-Syan Chen
NationalTaiwanUniversity
Abstract
This paper aims to investigate the impacts of the adoption of dividend imputation system by Taiwan government on Taiwanese firms’ financing constraints. The dividend imputation system adopted inTaiwan since 1998 was set up to resolve the double-taxation problem faced by Taiwanese firms.According to the system, the corporate income tax paid by the firms can be regarded as a deduction to thepersonal income tax when shareholders receive dividends. Hence, shareholders pay only either the corporate tax rate or the personal income tax rate on dividends, depending on which is higher. Adoption of dividend imputation system will enable the shareholders’after-personal-income-tax dividend income be greater than before even if firms’ profits do not increase. Hence, the shareholders’ wealth will be higher than before. The implication is that firms will be willing to payout more dividends than before.If firms pay out dividends in cash, they may encounter the problem of financing constraints, since firms tend to use internal source of funds to finance their investments. For those firms who remain paying out a great percentage of dividends in stock may not encounter the financing constraints problem, since their dividend decision haslittle to do with cash. It will be interesting to find out whether the adoption of dividend imputation has impacts on the degree of financing constraints for Taiwanese listed firms in the OTC as well as in the Exchange.
Firms listed in the OTC are mostly medium and small firms, while firms listed in the Taiwan Stock Exchange are mostly large firms. Medium and small firms are usually high-growth firms and tend to have difficulties in financing externally. Larger firms have stable performance record and good reputation, and have better access to external financing. Hence, it is also interesting to test whether the impacts of dividend imputation on the degree of financing constraints will be different for the OTC firms and the Exchange firms.Though the debate on whether the cash flow sensitivity in the traditional Q model can be employed as the degree of financing constraint or not is still going on, we follow the Fazzari-Hubbers-Peterson’s (1988) argument in this research.
Key research points:
- What is the role (personal and corporate ) income tax rates plays in determining the degree of financing constraints?
- How can the Dividend Imputation System have impacts on firms’degree of financing constraints? (The rationale?)
- What kind of firms will not be affected?(Low corporate income tax rates firms?)
I. Introduction
This paper aims to investigate the impacts of the dividend imputation on Taiwanese firms’ financing constraints. The dividend imputation system adopted by Taiwanese government since 1998 was set up to resolve the double-taxation problem faced by Taiwanese firms. Prior to 1998, shareholders who received dividends from Taiwanese firms suffered the double-taxation problem. Firms’ after-tax profits allocated to their shareholders would be regarded as one of their income items and taxed again. For firms with maximum corporate income tax rate of 25% and shareholders with maximum personal income tax rate of 40%, the real income tax burden for shareholders is 55%. This will definitely hamper the willingness of investors to pour more money to profitable companies.
After the adoption of dividend imputation system, we expect the double-taxation problem to be alleviated. Firms and investors will be willing to invest more in the new profitable production lines or companies.The after-personal-income-tax dividend income will be greater than before even if firms’ profits do not increase. Hence, the shareholders’ wealth will be higher than before. The implication is that firms will be willing to payout more dividends than before.
If firms pay out dividends in cash, they may encounter the problem of financing constraints, since firms tend to use internal source of funds to finance their investments. It will be interesting to find out whether the adoption of dividend imputation has impacts on the degree of financing constraints for Taiwanese listed firms in the OTC as well as in the Exchange.
For those firms who remain paying out stock dividends may not encounter the financing constraints problem, since their dividend decision has nothing to do with cash. This implication will also be tested as well. Unlike the dividend payout behavior of firms in the developed countries, Taiwanese firms prefer stock dividends to cash dividends. That is because local investors (shareholders) believe the ex-stock-dividend price of shares tends to recover to their pre-ex-dividend period very soon. For example, if a firm pays stock dividend of 20%, the investors of this stock will expect the ex-dividend stock price to shoot up 20% in a short period. This is an unique interesting phenomenon in Taiwan stock market.
Firms listed in the OTC are mostly medium and small firms, while firms listed in the Taiwan Stock Exchange are mostly large firms. Medium and small firms are usually high growth firms and tend to have difficulties in financing externally. Larger firms have stable performance record and good reputation, and have better access to external financing. Hence, it is also interesting to test whether the impacts of dividend imputation on the degree of financing constraints will be different for the OTC firms and the Exchange firms.
Black, Legoria, and Sellers (2000) studied the impact of adoption of the dividend imputation system by New Zealand and Australia on firm’s financing constraints. They indicated, in 1992, the U.S. Treasury proposed the elimination of the double tax on corporate dividends as a means of reducing the perceived bias against investment in the corporate sector. In 1987, New Zealand adopted dividend imputation and significantly lowed corporate taxes to eliminate the double tax on corporate dividends while stimulating economic growth.In 1987, Australia adopted a dividend imputation system similar to New Zealand’s, while imposing a capital gain tax on sales of stocks in the meantime. Major purposes of their paper include the determination of the effects of dividend imputation on capital investment and the
investigationof whether the effects will differ for New Zealand and Australia. They
divided the samples into two groups: high- and low-dividend portfolios and test the separate effects of dividend imputation and capital gains tax on capital investment.
II. Purposes of this paper:
(1) To investigate whether the adoption of dividend imputation in 1998 has impact on the capital investments and the degree of financial constraints of listed firms in Taiwan?
A slope dummy regression approach will be used to examine the difference of the regression coefficients before and after the dividend imputation.
(2) Whether the results in (1) will be different for the OTC firms and the TAIEX firms?
(3) Whether the results in (1) will be different for the China-concept firms and non- China-concept firms?
(4)How will the actual corporate tax rate (c) play an important role in this research?
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