The previous subsection suggested that some investors prefer dividends to share repurchases while others prefer share repurchases to dividends. However, the dividend tax borne by the taxable investor is likely to be larger than the transaction costs associated with a repurchase, suggesting that corporate values would probably increase if firms cut their dividends and repurchased shares instead. This has led a number of financial economists to suggest that the dividend policy of U.S. firms is somewhat of a puzzle.7
To understand why U.S. dividend policy is so puzzling, consider the situation in the United States during the 1960s and 1970s. The majority of investors during this period were individual investors, many of whom paid taxes at marginal tax rates as high as 70 percent. For these investors, the tax advantage of a share repurchase over a dividend was very large, but repurchases were uncommon at that time. While we can only speculate on why U.S. firms paid out so much in tax-disadvantaged dividends at that time, our best guess is that the decisions of financial managers at that time were simply wrong and that most shareholders would have been better off if corporations had cut dividends and, instead, repurchased shares.
The explosion in repurchase activity that began in the 1980s supports the hypothesis that most managers previously had misunderstood the relation between dividends and share repurchases and were changing their behavior to reflect their improved understanding of the tax advantage of share repurchases. Of course, other changes, such as the SEC ruling mentioned earlier, may have been taking place in the 1980s that would have made repurchases more attractive than dividends. However, the tax law changes in 1982 and 1986, which substantially decreased the tax disadvantage of dividends, should have had the opposite effect. In addition, the percentage of stock held by tax-exempt institutions greatly increased over this period, increasing the percentage of shareholders who might prefer dividends to share repurchases. These two changes had the effect of making dividends a relatively more attractive vehicle for paying out corporate cash than they previously were. Yet, share repurchases were, and still are, becoming increasingly popular.
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