Uncertainty and firm dividend policy—A natural experiment

Abstract

We examine how firms respond to uncertainty around U.S. tax policy changes, namely the individual level tax rate increases set to take effect on January 1, 2011 and January 1, 2013. We provide evidence that firms time the uncertainty in the tax environment and revise their dividend policy to an expected tax increase. We find that firms are likely to initiate their dividends or intensively increase their existing dividend amount one year before the expected tax increase. In addition, in 2012 when there is much less uncertainty on dividend tax changes than in 2010, firms are less likely to initiate a regular dividend but are more likely to initiate special dividends. The results suggest that firms facing less tax uncertainty are less likely to make long-term commitments on regular dividend payments but are more likely to take advantage of the lastminute low tax benefits by issuing special dividends. Furthermore, the response to the possible elimination of a tax cut was strongest in firms with high levels of tax-affected ownership, supporting the argument that when facing policy uncertainty, firms behave to prepare for the worst scenarios from the viewpoint of the shareholders, which in this case is a tax increase. Uncertainty and Firm Dividend Policy-A Natural Experiment 1. Dummy for Being Within 1 year of Tax Reform: It equals to one if the sample year is either 2010 or 2012, otherwise zero. 2) Other Variables: Age: Number of years since the firm observations were included in COMPUSTAT. Financing deficit: Sum of cash dividends, investments, and change in working capital minus internal cash flows, with all components scaled by the book value of total assets. See Frank and Goyal (2003) and John and Litov (2010) for details of the financing deficit calculation. Capital expenditures: Ratio of capital expenditures to the book value of total assets. 55 Cash: Ratio of cash plus marketable securities to net assets (i.e., book value of total assets minus cash plus marketable securities). Cash flow: Operating income before depreciation minus interest expenses, taxes, preferred dividends, and common dividends, scaled by total assets. Profitability: Ratio of operating income before depreciation to the book value of total assets. Market-to-book: Ratio of market value of assets to the book value of total assets, where the market value of assets is computed as the sum of the book value of total assets plus the market value of common stock minus the book value of commons stock. R&D: Ratio of research and development expense to total book asset, with R&D set equal to zero when research and development expense is missing. Investment growth rate: the ratio of previous year's capital expenditures to current year's capital expenditures minus one. Acquisition activity: Ratio of expenditures on acquisitions to the book value of total assets. Effective tax rate: the ratio of income taxes minus deferred taxes to pretax income. Net equity issuance: The split-adjusted change in shares outstanding times the split-adjusted average stock price...

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