Tax Preference Theory: Factors Affecting Dividend Payouts

Factors Affecting Dividend Payouts

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Question

According to the "Tax Preference Theory," which factor(s) would lead investors to desire a lower payout of dividends over a relatively higher payout of dividends?

I. Capital gains may be taxed at a lower marginal rate than ordinary income

II. The cost of retained earning equity capital is usually lower than debt capital

III. Capital gains are not taxed until the stock is sold and the gain is realized

IV. If the stock is held until the owner dies, the beneficiary may use the stock price at the time of inheritance as the basis, thus any capital gains up until that point are not taxed

V. Investors prefer a stable dividend policy

Answers

Explanations

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A. B. C. D. E.

C

The "Tax Preference Theory" states that there may be three reasons that investors would prefer lower dividend payments along with higher capital gains as opposed to high dividend payments. Long term capital gains may be taxed at a lower marginal rate than ordinary income (dividends). Also, investors have more control over when the taxable event occurs with capital gains. They are not taxed until the stock is sold and the gain is realized. Finally, if the stock is held until death, the beneficiary may claim the value at that time as the basis, thus avoiding taxes on any gains that previously accrued.

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