Why do firms pay dividends on stock? Since dividends are taxed more heavily than capital gains, this is not an idle question. The specific theory on “tax clienteles” was developed in the “Journal of Finance” by three economists, Franklin Allen, Antonio Bernardo and Ivo Welch, in 2000. Their theory revolves around the all-important tax distinction between an individual or an institution owning corporate stock.
This famous paper sought to explain why stock dividends remain popular even thought they are taxed more than capital gains. The basic variables are the firm itself and its dedication to good corporate governance. Another variable is whether the buyer is individual or institutional, and, finally, the all important tax distinctions between institutional and individual investors. Institutions such as pension funds or universities are not taxed at all, or taxed very little, and therefore, they seek dividends over capital gains.
The basic thesis and argument of the paper is that dividends are taxed differently depending on the nature of the investor. Institutions do not get taxed very much, and this goes far in explaining why dividends remain popular. The argument, however, is more complex than this. Institutions are the best kinds of investor to have. They are stable, wealthy and, most of all, are dedicated to seeking out firms that have the same qualities. Therefore, a corollary to the basic thesis is that firms give out dividends precisely to attract institutional as opposed to individual investment.
Institutions are more than just important and powerful investors. They are also more likely to have the resources and time necessary to seek out the best companies. This means that when a major institution like Harvard University or the Rockefeller Foundation invests in a firm, many others are likely to follow suit. In other words, when powerful and wealthy institutions invest in a firm, this is a signal to the market that the firm is an excellent one. Companies, therefore, pay out dividends because, given the tax distinctions between individual and institutional investors, institutions want the income stream. Individual investors want capital gains because these are taxed less than dividends, which are usually characterized as normal income for individuals.
The more powerful or wealthy an institution is, the more likely its stock purchase will be large enough to earn them a seat on the board. Corporations like to see institutional representation on the board for the same reason that these institutions are favored investors: Because they have the resources and staff to engage in skilled and competent corporate governance. In addition, having powerful foundations on the board also suggest to the market and other stockholders that the firm in question is considered trustworthy and able to successfully compete.
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