I finished reading the truly amusing book, Misbehaving, by Richard Thaler, a couple of weeks ago (see here for my review of the book), and beyond being a highly readable book (the book of the summer, in my opinion) with many entertaining stories, there is a passage which I found particularly interesting. It is in Chapter 17, where Thaler mentions a debate that took place in October 1985 at the University of Chicago on the empirical relevance of the Modigliani-Miller (M&M) dividend irrelevance proposition.
The M&M dividend irrelevance proposition says that the value of a company is independent of dividend policy – i.e. it does not matter whether the firm decides to pay more or less dividends. The argument is based on arbitrage: an individual investor will be indifferent between receiving cash-flows as dividends or as capital gains and, moreover, he or she will be able to undo corporate decisions by creating “home-made” dividends – i.e. selling (parts of) the shares. This result was achieved without taking into account the tax structure, because once the tax structure was included it distorted the relative value of dividends and capital gains for the investor. As it happens, in the 1980s dividends and capital gains were very different taxed in the US. It is worth quoting Thaler’s passage in full:
One of the key assumptions in the Miller-Modigliani irrelevance theorem was the absence of taxes. Paying dividends would no longer be irrelevant if dividends were taxed differently than the other ways firms return money to their shareholders. And given the tax code in the United States at that time, firms should not have been paying dividends. The embarrassing fact was that most large firms did pay dividends.
The way taxes come into play is that income, including dividend income, was then taxed at rates as high as 50% or more, whereas capital gains were taxed at a rate of 25%. Furthermore, this latter tax was only paid when the capital gain was realized, that is, when the stock was sold. The effect of these tax rules was that shareholders would much rather get capital gains than dividends, at least if the shareholders were Econs […] So the puzzle was: why did firms punish their tax-paying shareholders by paying dividends? ” (p.165, italics in the original)
An early answer to this “puzzle”, based on behavioural theory, was offered in a paper by H. Shefrin and M. Statman presented at the Chicago conference. They proposed to resolve the dividend puzzle using a mixture of self-control theory (people may wish to consume just dividend income, so as to enforce themselves to preserve capital for retirement), desire to segregate (if the value of stocks goes down, the dividend gain is viewed as a “silver lining”) and regret aversion (it is not the same to consume out of just-received dividends than to consume out of the selling of shares). They made very clear throughout their paper, that they want to emphasise that the dividend-and-capital-gains equivalence may not hold even in the absence of taxes and transactions costs (the best-case scenario for M&M) due to behavioural considerations. Continue reading