Tax Shield and Its Impact on Corporate Dividend Policy: Evidence from Pakistani Stock Market

doi:10.4236/ib.2013.54023

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iBusiness, 2013, 5, 184-188

Published Online December 2013 (http://www.scirp.org/journal/ib)

http://dx.doi.org/10.4236/ib.2013.54023

Open Access IB

Tax Shield and Its Impact on Corporate Dividend Policy:

Evidence from Pakistani Stock Market

Akhlaq ul Hassan1, Mubashar Tanveer2, Muhammad Siddique3, Muhammad Mudasar4

1I-Mtas College Sinllanwali, Sargodha, Pakistan; 2University of Sargodha, Sargodha, Pakistan; 3Universiti Teknologi Malaysia, Johor

Bahru, Malaysia; 4Govt College of Commerce Shahpur Sadar, Sargodha, Pakistan.

Email: [email protected]

Received July 5th, 2013; revised August 5th, 2013; accepted September 5th, 2013

which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

ABSTRACT

The problem: what is the taxation impact on dividend policy? While much optimal taxation research focuses on the e-

conomic effects of taxation, the purpose of this study is to add a new dimension by investigating the relationship be-

tween taxation and payout ratio and some other variables of dividend policy. These relations are tested using the data

from financial statements of KSE listed companies. The results show that tax shield has no significant relation to the

dividend payout ratio but mostly dividend policy is due to the size of the firm and its profitability.

Keywords: Dividend Policy; Tax Shield; Determinant’s of Dividends

1. Introduction

A snowy debate in finance and public economics litera-

tures about the role of taxation in corporate dividend

policies is there. Taxes and dividend policy are the one of

the very important topics of corporate finance, as well as

for the Pakistani stock market. A lot of arguments re-

garding taxes and dividend policy have attracted many

educational researchers. Dividends, since the days of Mil-

ler and Modigliani, have been a topic of extensive re-

search in academia and the debate between practitioners.

Dividends provide “recompense” in a sense to investors

who have taken a menace by investing in the stock of a

certain company. Income that is earned by the company is

distributed to shareholders, and repeatedly increases over

time. They are normally paid on a regular basis, such as

quarterly. Companies that have a record of paying divi-

dends are usually traded at a first-class versus those that

do not. Investors in the company are thus provided cash

flow without having to sell shares; therefore, traditionally,

companies paying relatively high dividends have been

purchased by those on a fixed income. Manager’s base

current dividend levels of past dividend levels and current

earnings and imagine dividends are steady over time [1].

On the other side, some theories have conservative opin-

ion that dividend policy is applicable due to the exist-

ence of differential taxes in the market [2] (Poterba and

Summers, 1984; Ang et al., [3,4]). Others disagree that

“Clientele Effects” matter in dividend policy decisions

(Pettit, 1977; Scholz, 1992). It is because investors’ pref-

erences divide them in groups that tend them to select a

company where their investment goals and dividend pol-

icy are associated. Signaling models focus on allaying the

information asymmetries. The former known as “Signal-

ing” theory, assumes that the dividend is one of the

sources through which a company can suggest informa-

tion to the market (Bhattacharya, 1979; [5,6]). According

to this theory, the dividend can moderate information

asymmetries between managers and shareholders by

conveying inside information of a firm’s future prospects.

The latter, known as “Agency” theory, argues that the

dividend reduces the costs of shareholder-manager con-

flict and it performs a controlling function where moni-

toring of a firm’s management by its Shareholders is in-

active [7]; Easterbrook, in 1984, [8] argues that by paying

dividends the flexible resources under managerial control

can be decreased and in this way the over investment

difficulty can be determined. Actual company earnings

are another key determinant of dividend payouts. There is

a statistically significant relationship between dividends

and earnings [9,10] (Hsu, Wang, & Wu, 1998; Lintner,

1956). Bhattacharya (1979), Miller and Rock (1985) [11]

show that adjustments in dividend payments are con-

nected to changes in earnings. A relationship between

dividends and earnings is also reported in other studies

Tax Shield and Its Impact on Corporate Dividend Policy: Evidence from Pakistani Stock Market 185

[12,13] (Watts, 1973, Gonedes, 1978, Lee & Kau, 1987).

Analyzing time series and cross-sectional data, Fama

shows that dividends and earnings are extremely corre-

lated. However, a survey with 384 financial executives

conducted by Brava, et al. (2005) shows that the connec-

tion between earnings and dividends has weakened the

market debt to capital ratio which is another possible

explanation of the variability in dividend payments. Sev-

eral papers have found a negative relationship between

leverage and dividend payout ratios. This negative rela-

tionship is plausible due to the extent that debts and divi-

dends are substitutes employed by managers to mitigate

agency conflicts or asymmetric information problems,

and this implies that an increased market debt to capital

ratio reduces dividend payout rates and vice versa. The

objective of this study is to assess the effect of tax shield

on the dividend policies in the KSE listed companies of

Pakistan. This study will also evaluate the role of taxes to

establish the dividend policies of the corporate sectors.

This study has the capacity to be helpful to policy makers

to better recognize how taxes impact dividend policies and

they will be in a better position to develop dividend poli-

cies by keeping in view of the influence of taxes. Before

conducting this study, our expectation was that tax saving

would directly go to the shareholders of the company.

2. Literature Review

[14] suggested in their study that before- and after-tax

returns to capital cannot be precisely estranged from the

tax system. They emphasized that in the best dividend

payout behavior, one cannot be separated away from

equilibrium concern and the analysis of the effect of

taxation on business valuation. [15] proposed that due to

the impediment in personal tax advantage of dividend, the

shareholder greatly prefers to invest in real assets to use

internal financing as compared to external. The profit-

ability of internally financed security investment is de-

pendent on the tax status of security and also the tax

bracket of shareholder. In contrast, externally-financed

security purchases are making loss from a tax stand point.

[16] evaluated the tax effect on dividend policy of Nige-

rian banks and proposed in their study that various factors

influenced the dividend pattern of companies. Due to the

accessibility of the profit, the dividend policy of the banks

is to frequently sustain a low but constant payout. The

most important factor of the dividend structure is the

liquidity position of the company. Dividend clients are a

very alarming aspect in the concern of a dividend policy.

[17] identified the signaling equilibrium with taxable

dividends in their theory. They described in their theory

that the employees of the organization, with more essen-

tial and confidential information, best allocate larger

dividends and obtain higher prices for their stock when-

ever firms have a demand of cash; thus, its existing

stockholders exceed its internal supply of cash. Green et.

al. (1993) questioned the irrelevance argument and in-

vestigated the relationship between the dividends and

investment and financing decisions. Their study showed

that dividend payout levels are not totally decided after a

firm’s investment and financing decisions have been

made. Dividend decision is taken along with investment

and financing decisions. The results however do not

support the views of Miller and Modigliani (1961) [18].

Partington (1983) revealed that firms’ use target payout

ratios, firms’ motives for paying dividends and extent to

which dividends are determined are independent of in-

vestment policy. [19] indicates a direct link between

growth and financing needs: rapidly growing firms have

external financing needs because working capital needs

normally exceed the incremental cash flows from new

sales. Higgins (1972) shows that payout ratios are nega-

tively related to firms’ need top fund finance growth op-

portunities. Rozeff (1982), Lloyd et al. (1985) and Collins

et al. (1996) all show significantly negative relationship

between historical sales growth and dividend payout. D,

Souza (1999) however shows a positive but insignificant

relationship in the case of growth and negative but insig-

nificant relationship in case of market to book value. In

the seminal work on dividends and company’s’ maturity,

Grullon et al. (2002) analyzed listed companies of New

York (NYSE) and American (AMEX) stock exchanges

between 1967 and 1993. They argued that company that

increases dividends experience a significant decline in

their systematic risk and such companies do not increase

their capital expenditure and experience a decline in

profitability in the years after the change in dividends.

They proposed an alternative explanation of Jensens’s

(1986) free cash flow hypothesis known as “Maturity

Hypothesis”. According to them in growing stage a com-

pany has many positive NPV projects and it earns large

economic profits with high level of capital expenditure.

Such companies are left with low free cash flows and

experience rapid growth in their earnings. But as a com-

pany continues to grow due to market competition, its

share price is cannibalized which reduces its profits. In

this transition phase, the company’s investment opportu-

nities begins to shrink and pace of its growth becomes

slow, hence company starts generating larger amount of

free cash flows. Ultimately it enters into maturity phase in

which the return on investment is close to the cost of

capital and its cash free cash flows are high. These mature

companies are now able to pay higher dividends. Ahmed

and Javid [20] proposed in their study that whenever the

non-financial companies of Pakistan quoted on Karachi

Stock Exchange set their dividend payments, these firms

consider the existing earning per share and past dividend

patterns. But, the tendency of dividend should be more

responsive to current earnings than previous dividends.

The listed non-financial companies having high momen-

Open Access IB

Tax Shield and Its Impact on Corporate Dividend Policy: Evidence from Pakistani Stock Market

Open Access IB

186

tum of modification and low target payout ratio, show

instability in smoothing their dividend payments. It is

evident from existing literature that very few researchers

have analyzed the relationship of tax shield and dividend

policy. Although, many researchers have used taxation

and dividend policy, but to the best of authors’ knowledge,

none of the researchers have analyzed the nature of the

relationship between tax shield and dividend policy in

Pakistan. The main objective of present study is to analyze,

using a non-linear model specification, whether mature

companies pay more dividends or not?

3. Objective & Expectation

The objective of this study was to find out the relationship

between the tax shield and dividend payout ratio and

expectation was that tax shield would impact the posi-

tively on dividend payout policy.

4. Data Collection & Methodology

For present study a sample penal data of 33 companies

listed at Karachi Stock Exchange (KSE) has been col-

lected for the period of six years i.e. from 2005-2010.

Companies were listed at KSE during years 2005 to 2010.

Should not be a State Owned Enterprise. Panel regression

is among the widely used technique to investigate the

impact of firm specific characteristics on dividend We

have used the same estimation technique to analyze the im

pact of ownership structures and cash flow characters on

dividend behavior of companies listed in KSE Pakistan.

Payout ratio is used as a proxy of dividend policy, which

was calculated by dividend per share with EPS. Debt to

equity ratio is used as a proxy of leverage. Moreover, tax

shield was calculated by multiplying the tax rate with

interest amount. Return on asset is used as a proxy of

profitability. Size was calculated by taking the log of total

assets.

5. Results and Discussion

Table 1 shows the mean, standard deviation, skewness etc.

For measuring the deviation of the variables from each

other’s as its objective is to investigate the relationship

between tax shield and dividend policy. Table 2 shows

that p-value of F-statistic are less than 0.05. Moreover,

F-statistic value is non-zero. Both these values prove the

model fitness. R square value shows that 7.23% variation

in dependent variable is explained by independent vari-

ables. In addition to this, results shows that there is in-

significant value between leverage and dividend policy as

its p-value is greater than 0.05.

Results also showed that there is significant positive

relationship between profitability and dividend policy. Its

beta co-efficient value is 0.000908 and there is insignifi-

cant relation between the leverage and the dividend policy

as its co-efficient is −0.000450 and also insignificant

relationship between tax shield and dividend policy as its

co-efficient is −0.005327 and insignificant relationship

between the size of the firm and dividend policy as its

co-efficient is 0.007738.

Table 1. Descriptive statistics.

PAY LEV PROF SIZE TS

Mean 0.027734 1.014639 10.14954 14.38144 8.879438

Median 0.015676 1.075000 10.07500 15.00000 8.797155

Maximum 0.593824 9.710000 53.51000 17.00000 12.75032

Minimum −0.714286 −14.75000 −46.73000 11.00000 2.734368

Std. Dev. 0.084186 2.447218 16.72553 1.529965 1.981065

Skewness −0.992175 −2.178721 −0.260952 −0.196899 −0.270824

Kurtosis 46.19498 15.63794 3.648231 2.224797 2.680634

Jarque-Beta 15113.76 1444.531 5.598424 6.111124 3.195959

Probability 0.000000 0.000000 0.060858 0.047096 0.202305

Sum 5.380321 196.8400 1969.010 2790.000 1722.611

Sum Sq. Dev. 1.367854 1155.853 53990.45 451.7732 757.4514

Observations 194 194 194 194 194

Tax Shield and Its Impact on Corporate Dividend Policy: Evidence from Pakistani Stock Market 187

Table 2. Regression analysis.

Dependent variable: PAY

Method: panel least squares

Sample: 2005 2010

Periods included: 6

Cross-sections included: 33

Total panel (unbalanced) observations: 194

Variable Coefficient Std. error t-statistic Prob.

Intercept −0.045003 0.059240 −0.759678 0.4484

LEV −0.000450 0.002435 −0.184959 0.8535

TS −0.005327 0.004029 −1.322216 0.1877

PROF 0.000908 0.000418 2.168689 0.0314

SIZE 0.007738 0.005387 1.436339 0.1526

R-squared 0.072338 Mean dependent var 0.027734

Adjusted R-squared 0.052705 S.D. dependent var 0.084186

S.E. of regression 0.081938 Akaike info criterion −2.140280

Sum squared resid 1.268906 Schwarz criterion −2.056057

Log likelihood 212.6071 Hannan-Quinn criter. −2.106175

F-statistic 3.684498 Durbin-Watson stat 1.712100

Prob (F-statistic) 0.006493

6. Conclusion

The conclusion is that the firm size and profitability are

positively related to the dividend payout policy. Whereas,

our study showed the insignificant relationship between

the tax shield and leverage on the dividend payout policy.

Positive results mean that, if the company size and prof-

itability increase, the company will pay more dividends

whereas the tax shield and leverage will not affect the

dividend policy. Our study supports some studies and also

does not support some research findings. We support

Talat Afza and Hamad Hassan Mirza’s findings in 2010

and do not support the Kanwal Anil Study in 2008.

7. Limitations

This study is limited to the KSE and may not apply the

other countries and this sample shows these results other

study may find the different results more sample size may

shoe the difference result.

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