Two Essays on Corporate Income Taxes and Organizational Forms in the United States

Transcription

1 Two Essays on Corporae Income Taxes and Organizaional Forms in he Unied Saes A Disseraion Presened o The Academic Faculy By Zhenhua Hu In Parial Fulfillmen Of he Requiremens for he Degree Docor of Philosophy in Public Policy Georgia Sae Universiy And Georgia Insiue of Technology May, 2006 Copyrigh 2006 by Zhenhua Hu

2 Two Essays on Corporae Income Taxes and Organizaional Forms in he Unied Saes Approved by: Dr. Gregory B. Lewis, Advisor School of Policy Sudies Georgia Sae Universiy Dr. Douglas Noonan School of Public Policy Georgia Insiue of Technology Dr. Michael Rushon School of Policy Sudies Georgia Sae Universiy Dr. Bruce Seaman School of Policy Sudies Georgia Sae Universiy Dr. Sally Wallace School of Policy Sudies Georgia Sae Universiy Dae Approved: January, 2006

3 [To my wife Jialin Yi]

4 ACKNOWLEDGEMENTS I would like o express my sincere appreciaion o my advisor, Dr. Gregory Lewis, and o disseraion commiee members, Dr. Sally Wallace, Dr. Michael Rushon, Dr. Bruce Seaman, and Dr. Douglas Noonan. Wihou heir guidance and help, I could have never have compleed his disseraion. I would also like o hank Dr. David Sjoquis, who generously allowed me o use he ax revenue daase from Georgia Deparmen of Revenue. Finally, I exend my special hanks o my wife, Jialin Yi, who suppors me all he ime. Her encouragemen, consideraion, and love susained me hrough his journey. iv

5 TABLE OF CONTENTS Page ACKNOWLEDGEMENTS LIST OF TABLES LIST OF FIGURES LIST OF SYMBOLS AND ABBREVIATIONS SUMMARY iv vii viii ix x CHAPTER CHAPTER INTRODUCTION 2 CHAPTER 2 ESSAY ONE: THE IMPACT OF CORPORATE INCOME TAX ON THE COST OF CAPITAL NEW EVIDENCE FROM C VERSUS S CORPORATIONS 4 2. Inroducion Lieraure Review A Brief Inroducion of S Corporaions Mehodology: Cos of Capial and C vs. S Corporaions Daa Findings: Dividend Payou Raio and C vs. S forms CIT Rae and he Choice of C vs. S forms Findings: CIT and C vs. S forms Regression wih an Insrumenal Variable Conclusions 43 3 CHAPTER 3 ESSAY TWO: CORPORATE INCOME TAX AND NONPROFIT VERSUS FOR-PROFIT ORGANIZATIONS Inroducion Lieraure Review 49 v

6 3.3 A Regression Model Hospial Daa and CIT Hisory Analysis and Resuls Conclusions and Discussion 83 4 CHAPTER 4 FURTHER DISCUSSION 90 REFERENCES 94 VITA 0 vi

7 LIST OF TABLES Page Table 2.: Comparison of Cos of Capial under Differen Views for Differen Forms 2 Table 2.2: Mean and Sandard Deviaion of Variables in he Sample 28 Table 2.3: OLS Regression Resuls of Dividend Payou Raio 32 Table 2.4: Logisic Regression Resuls 40 Table 2.5: Regression Resuls wih Insrumenal Variables 42 Table 3.: Non-Saionariy Tess of Dependen and Independen Variables 7 Table 3.2: Auocorrelaion Check of Firs-Differenced Variables 73 Table 3.3: ARIMAX Regression Resuls 75 Table 3.4: Arellano-Bond Regression Resuls 82 vii

8 LIST OF FIGURES Figure 2.: Cos of Invesmen Financing 23 Figure 3.: Marke Share of Nonprofi vs. For-profi Organizaions 57 Figure 3.2: Nonprofi Hospial Marke Shares Time Trend 64 Figure 3.3: Average CIT Rae across Sample Years 67 Figure 3.4: Nonprofi o For-Profi Raios of Average Expendiure and Average Price 69 Figure 3.5: Price/Expendiure Raios for Nonprofi and For-Profi Hospials 69 Figure 3.6 Impacs on Nonprofi Hospials Marke Share from One Percenage Poin Increase in CIT Rae 75 Page viii

9 LIST OF SYMBOLS AND ABBREVIATIONS m τ z ρ Shareholder s marginal ax rae on dividend Effecive corporae income ax rae Shareholder s accrual capial gain ax rae Shareholder s required rae of reurn D Dividend a ime. D 0 V N K I New share issued a ime Capial sock a ime Capial invesmen a ime π( ) Preax profiabiliy funcion N V Minimum level of new share issues μ, λ, η, and ξ Lagrange mulipliers g Relaive of nonprofi firm over for-profi firm ix

10 SUMMARY Corporae income axaion has a profound impac on economic behavior in he Unied Saes. This disseraion focuses on wo aspecs: he impac of dividend axaion on invesmen and he impac of corporae income ax exempion on nonprofi organizaions aciviy. The firs essay compares dividend payou raios of C and S corporaions o es he validiy of he radiional and he new views on dividend axaion. Average corporae income ax rae is used as an insrumenal variable. The resuls suppor he radiional view. The second essay focuses on wheher he exempion of nonprofi organizaions from he corporae income ax affecs he compeiion beween for-profi and nonprofi hospials. Time series and panel daa analysis show ha ax subsidies o nonprofi organizaions have a posiive impac on nonprofi hospials marke share. x

11 CHAPTER INTRODUCTION Corporae income ax rules in he Unied Saes are complicaed and always conroversial. Economic eniies wih differen organizaional forms are axed differenly. High corporae income ax raes drive corporaions o conver ino ax-exemped forms. Economiss and policy makers are keen o find ou how he relaionship beween various forms and ax rules influences he general economy and social welfare. Empirical research in his field can provide insighs in economic modeling of income axes and generae deep policy implicaions for corporae income ax reform. One heaedly debaed opic is wheher he double axaion of dividends negaively affecs invesmen in he corporae secor. Managers of profiable corporaions have o decide wheher o disribue hose afer-ax profis o shareholders as dividends or o reain he earnings o finance new invesmens. The radiional view holds ha dividends have he exra funcion of profi signaling. Therefore, corporae managers end o disribue more dividends han hey would if dividends only served as a way of profi disribuion. Thus corporaions do no have adequae reained earnings o finance marginal invesmen and have o issue new shares o raise capial for new projecs. The double axaion of dividends increases he cos of capial and hus reduces he overall invesmen level in he corporae secor. Therefore, supporers of he radiional view call for ax reforms o inegrae he corporae income ax and personal income ax on dividends.

12 However, he new view holds ha dividends do no serve any exra funcion of profi signaling, so managers of profiable corporaions always reain enough afer-ax profis o finance marginal invesmen and disribue he residual profis o shareholders. Thus, dividends are disribued regardless of he ax cos, and double axaion of dividends does no negaively reduce he invesmen in corporae secor. Raher, firms disribue profis as dividends only if hey have no more profiable invesmen opporuniies; he ax is no foreclosing any profiable invesmens. Therefore, supporers of he new view objec o a reform o eliminae ax on dividends, fearing such eliminaion would grealy reduce federal ax revenue. A second conroversial opic is he corporae income ax s impac on for-profi and nonprofi organizaions (NPOs). NPOs play an indispensable role in he Unied Saes. They provide goods and services o he sociey when he governmen fails o provide enough o is people. Researchers have been inquiring wheher he governmen s ax subsidies o he nonprofi organizaions are imporan o heir exisence and o compeiion wih for-profi counerpars. If hey do no respond o he exempion of various axes, hen axing hem in he same way as for-profi organizaions will boh increase ax revenue and level he playing field. On he oher hand, he proof of a posiive relaionship beween ax exempion and nonprofi aciviies helps policy makers o deermine he righ measure o regulae NPOs in heir desired direcion. This disseraion sudies hese wo opics in wo essays. The firs essay explores he differen ax reamen of C and S corporaions and shows ha he dividend payou raios of C and S corporaions should differ under he radiional view bu no under he new view. Thus i examines he validiy of he radiional and new views by comparing 2

13 he dividend payou raios in C and S forms. Applying he es on a confidenial ax reurn daase provided by Georgia Deparmen of Revenue, I find empirical resuls supporing he radiional view. The second essay focuses on he impac of federal corporae income ax exempion on he marke shares of nonprofi hospials. The sudy of naional level and sae level aggregae marke shares provided in Hospial Saisics published by he American Hospial Associaion shows ha he ax exempion does posiively affec nonprofi hospials marke shares. 3

14 CHAPTER 2 ESSAY ONE: THE IMPACT OF THE CORPORATE INCOME TAX ON THE COST OF CAPITAL NEW EVIDENCE FROM CHOICE OF C VS. S CORPORATE FORMS 2. Inroducion U.S. business and personal income ax rules subjec corporae income firs o he corporae income ax (CIT) a he corporae level and hen o he personal income ax when dividends are disribued. If corporaions do no disribue he profis as dividends, shareholders pay axes on heir capial gains when hey sell heir shares. Therefore, corporae income is axed wice. Economiss and policy makers are eager o find ou wheher his double axaion of dividends increases he cos of capial and disors invesmen behavior in he corporae secor. Some scholars believe ha i does and call for dividend ax cu, while ohers disagree. However, despie decades of debae, no agreemen has been reached. Empirical research on his opic will no only conribue o he esablishmen of a correc heoreical framework, bu also will have policy implicaions on ax reforms. There are wo compeing views on he axaion of dividends. The radiional view argues ha dividends are no only a way of disribuing corporae profis o shareholders, bu also have oher uiliies such as signaling profi o build up invesors confidence and saisfying invesors preference o have cash in heir hands raher han in he corporaions. Therefore, corporaions have he endency o disribue he profis o shareholders despie 4

15 he double axaion of dividends. However, he dividend ax increases he cos of profi signaling and decreases he rae of reurn of capial for corporae invesors. As a resul, i increases he cos of capial and lowers overall invesmen level in he corporae secor. Therefore is supporers have proposed he inegraion of corporae and personal income ax o reform he U.S. income ax sysem. Hubbard (993) saes ha he U.S. Treasury holds he radiional view and advocaes inegraion of corporae income ax and individual income ax on dividends. However, he new view, proposed by King (977) and Auerbach (983a, 983b) believes ha maure firms only disribue dividends when hey have reained enough earnings o finance he marginal invesmen and dividends are only he residuals of profis afer reained earnings; hese dividends are disribued anyway no maer how high he dividend ax is. Therefore dividend ax is neural and does no affec corporaions dividend disribuion and invesmen behavior; hus inegraion of corporae income ax and individual income ax on dividends will no increase invesmen by much bu will reduce federal ax revenue. Sinn (99) saes ha he major reason Congress did no follow he Treasury Deparmen proposal o inegrae CIT and individual income ax in 986 was ha i feared ha he inegraion would subsanially lower revenue wihou creaing significan efficiency gains. Each view is appealing under is assumpion abou he funcion of dividends, and i is no possible o judge he views validiy by only looking a heir heoreical frameworks; we have o resor o empirical evidence o deermine which view is more correc. However, empirical analysis ha ess hese compeing views is limied due o he lack of appropriae daa. 5

16 The comparison of dividend policy among differen organizaional forms may shed some ligh on how o es hese compeing heories. The S corporaion, a relaively new bu mushrooming organizaional form, is differen from he radiional corporaion (which is hereafer called a C corporaion), he noncorporae forms, and oher hybrid forms. I enjoys he limied liabiliy of a C corporaion, which means ha is shareholders only risk he amoun of money hey inves in he corporaion raher han all of heir wealh, bu i is axed similarly o a parnership, which means ha i does no pay CIT and all is profis and losses are passed hough o shareholders and are only subjec o individual income ax. The comparison of dividend policy in S and C corporaions provides a good es of compeing views on axaion of dividends. This paper focuses on C and S corporaions and sudies he impac of corporae income ax on invesors choice beween S and C forms by using individual firm-level ime-series informaion from a confidenial ax reurn daase in Georgia. I firs derives he cos of capial for C and S corporaions under differen views wihin he neoclassical economic framework. Then i ess he compeing views abou dividend axaion. If he radiional view more accuraely reflecs he fac han he new view, hen he choice of an S or a C organizaional form should affec he dividend paymen and S corporaions should pay a higher proporion of profis as dividends. However, if he new view is correc, hen dividends are jus he residual of corporaions profis afer new invesmen, and dividend paymen is no affeced by he organizaional form. Thus, his paper ess he hypohesis ha S corporaions have higher dividend payou raios han C corporaions because hey avoid he double axaion of corporae income. 6

17 However, here is an endogeneiy problem in ha corporaions wih higher dividend payou raios migh selec o be S corporaions in order o avoid CIT. Thus insrumenal variables are necessary. The lieraure has shown ha average CIT rae affecs organizaional forms. Empirical analysis of he daa provides evidence ha he higher he effecive CIT rae is, he more likely a corporaion is o choose he S form in order o minimize income ax paymen. Therefore, he average CIT rae in he preceding year is used as an insrumenal variable. The final empirical resuls confirm he radiional view. Following he logic in he above paragraph, secion 2.2 reviews he lieraure abou he compeing views on he dividend axaion. Secion 2.3 gives a comprehensive descripion of S corporaions ax rules and hisory. Secion 2.4 shows he heoreical framework using he cos of capial and ses up he hypohesis. Secion 2.5 describes he daa from he Georgia ax reurn files and he adjusmens made o fi i for he analysis in his paper. Secion 2.6 ess he hypohesis ha organizaional form affecs dividend payou raio and shows findings ha S corporaions pay higher proporion of profis as dividends. Due o he endogenous relaionship beween organizaional forms and dividend payou raio, average CIT rae is used as an insrumenal variable. Secion 2.7 draws suppor from he lieraure, showing ha average CIT rae affecs he decision of organizaional forms. Secion 2.8 ess wheher average ax rae affecs he choice of organizaional form in my daa. Secion 2.9 re-ess he relaionship beween organizaional form and dividend payou raio, correcing for he endogeneiy problem and secion 2.0 concludes his paper. 7

18 2.2 Lieraure Review Differen heories abou dividend axaion provide differen guidelines and evaluaion of federal income ax reform. Numerous sudies have examined why corporaions pay dividends despie he ax penalies on dividends from he double axaion, bu no consensus has emerged. The mos influenial heories are caegorized ino wo groups: he radiional view and he new view. The lieraure is abundan wih aricles summarizing hese heories and sudies esing hem (e.g., Poerba, 987; Sorensen, 995; and Carroll e al., 2003). The dispue beween he radiional and new views ceners on he differen assumpions abou he funcion of dividends: wheher dividends have more funcions han ha of disribuing profis o shareholders. If dividends have more funcions han serving as a means of profi disribuion, as he radiional view assumes, hen corporaions will disribue a higher proporion of profis o shareholders and he remaining reained earnings will no be enough o finance new invesmens. According o he new view, maure corporaions finance marginal invesmens from reained earnings; afer hey run ou of invesmen opporuniies, hey disribue he remaining profis o shareholders as dividends. Scholars on boh sides use he neoclassical economic framework of user cos of capial iniiaed by Jorgenson (963) and Hall and Jorgenson (967) o explain and jusify heir argumens. The user cos of capial is defined as he required rae of reurn on he capial invesmen; he higher he cos, he lower he capial invesmen and he smaller he capial sock in he corporae secor. Supporers of he radiional view believe ha he double axaion of dividends increases he cos of capial, while he new view supporers believe ha i does no. 8

19 The discussion of he radiional and new views is limied o maure firms, which are defined as firms o having limied invesmen opporuniies so ha heir profis are high enough o cover all hose opporuniies. However, his definiion does no explicily include growing corporaions ha do no have enough profis o finance heir desired invesmen. To make up his gap, Sinn (99) follows he line of argumen used by he new view and proposes he nucleus heory ha growing corporaions are esablished wih limied iniial capial bu are expanded hrough reained earnings. No dividend is disribued before corporaions reach he maure phase. Afer enering he maure phase, corporaions disribue dividend ou of he profi ha remains afer he firms deplee all of he invesmen opporuniies, as prediced by he new view. Empirical ess of he wo views are limied and he resuls are mixed. There were six influenial empirical sudies in he 980s by Gordon and Bradford (980), Poerba and Summers (984), Poerba (987), Nadeau (988), Auerbach (984), and Bagwell and Shoven (989). However heir conclusions are mixed, wih some supporing he radiional view and ohers supporing he new view. Moreover each sudy is flawed, wih some dubious resuls or inerpreaion (Zodrow, 99). Two addiional sudies were done in 994 and Genry (994) explois he differen ax reamen of publicly raded parnerships (PTP) and corporaions and uses firm-level daa o sudy he relaionship beween he dividend payou raio and PTP versus corporaion forms. He argues ha he ax cos of dividends is lower for PTP firms han for corporaions. According o he nucleus heory and he new view, dividend paymen is no affeced by dividend ax cos because dividend is paid only as remaining profi afer he corporaions deplee heir invesmen opporuniies. However, he 9

20 radiional view predics ha dividend payou raio is affeced by he cos of dividend ax. His resul shows ha PTP firms pay a significanly higher proporion of heir profis as dividends han corporaions so ha he radiional view is more likely o be correc. Genry (994) explains ha dividend payou raio should differ for PTPs and corporaions under he radiional view because he cos of signaling of dividend is lower for PTP han corporaions. However, his explanaion is more inuiive han heoreically sound and more rigorous proof is necessary. In 987, Ausralia and New Zealand adoped similar dividend impuaion sysems o allow dividend axes on he personal level o be offse by some credis derived from corporaions CIT paymen. The new dividend impuaion sysems reduced he ax cos of dividends and are expeced o increase capial invesmen under he radiional view bu o have no significan impac under he new view. Black, Legoria and Sellers (2000) find evidence ha dividend impuaion increases corporae capial invesmen, supporing he radiional view. More empirical evidence using differen mehodology is necessary o es he validiy of he radiional and new views. The difference of C and S forms provides anoher angle o examine he heories and design an empirical es. This paper compares he dividend payou raios in C and S corporaions o es he compeing views. 2.3 A Brief Inroducion of S Corporaions In he Unied Saes, economic eniies ake various organizaional forms, including corporaions, ypical noncorporae eniies (i.e., sole proprieorships and parnerships), and hybrids of noncorporae and corporae forms, (e.g., publicly raded parnerships). Congress creaed he S corporaion in 958. According o U.S. Code (958, 0

21 page 4876), Congress believed ha i is desirable o permi businesses o selec he form of business organizaion desired, wihou he necessiy of aking ino accoun major differences in ax consequence.... Also, permiing shareholders o repor heir proporionae share of he corporae income, in lieu of a corporae ax, will be a subsanial aid o small business.... The provision will also be of subsanial benefi o small corporaions realizing losses for a period of years where here is no way of offseing hese losses agains axable income a he corporae level, bu he shareholders involved have oher income which can be offse agains hese losses. Therefore, Congress enaced he Technical Amendmens Ac of 958, requiring he IRS o give small businesses an opion o choose wheher o have heir ne business income exemped from he CIT. According o IRS regulaions, an S corporaion begins is exisence as a general for-profi corporaion upon filing he aricles of incorporaion a he sae level. However, afer he corporaion has been formed, i may elec S Corporaion Saus by submiing IRS form 2553 o he Inernal Revenue Service. Once his filing is complee, he IRS refers o he business as an S corporaion Corporaions which do no file IRS form 2553 are referred as C corporaions. An S corporaion is axed similarly o a parnership raher han as a C corporaion. Thus, is ne income or loss is passed hrough o is shareholders for he purpose of compuing ax liabiliy. Ne income, wheher he corporaion acually disribues i or no, is passed hrough o he shareholders and axed based on heir personal income ax raes. Losses are passed hrough o shareholders who can use i o offse personal income from oher sources. In cerain circumsances, he S form saves more money in axes han he C form for businesses wih profis or losses. However, Congress se several requiremens for small

22 corporaions o qualify as S corporaions. Those major requiremens included he following: The corporaion can have no more han 0 shareholders. All shareholders mus be eiher U.S. ciizens or permanen residen aliens, and non-residen aliens are no accepable. The corporaion mus have issued only one class of sock. No more han 80% of is gross receips can be from sources ouside he Unied Saes. No more han 20% of he corporaion's gross receips can be derived from passive invesmen aciviies. However, S corporaions were no axed in he same way as parnerships a ha ime because S corporaion shareholders were no allowed o carry losses over, while parnership shareholders were. The Subchaper S Revision Ac of 982 increased he maximum number of shareholders o 35, eliminaed he requiremen of no more han 80% of gross receips from abroad, and mandaed ha S corporaions be axed in he same way as parnerships. The S form sared o be a real opion for small businesses. The S form has benefis over he C form in various circumsances. Scholes e al. (2002) creaed a simple example o illusrae ha he double axaion of he corporae income means ha a dividend-paying C corporaion mus pay a higher before-ax rae of reurn han a similar S corporaion. The longer he ime span of he invesmen, he lower he difference in required raes of reurn; bu a difference persiss even when he ime span increases o fify years. 2

23 However, Hulse and Pope (996) argue ha if boh C and S corporaions do no pay any dividend and use all of heir profis o finance similar new projecs, hen C shareholders will pay less income ax han S shareholders. Their argumen is rue in he years when he CIT rae is lower han individual income ax rae. Even hough C shareholders are axed by capial gain ax when hey sell heir shares years laer, hey sill pay a combined income ax less han S shareholders because he capial gain ax rae is low compared wih he individual ax rae and is axed only on he realizaion dae, which means ha is accrual rae (i.e., is yearly equivalen rae) is negligible. For example, axing he income from selling currenly held socks in en years wih he capial gain ax rae of 28% is equivalen o axing he income wih a rae of.4% every year ([- 0.28]=[-accrual rae] 0 ). If he CIT rae is 35% and he individual income ax rae is 39%, hen C shareholders combined yearly income ax rae is 36% (=-[-0.35]*[- 0.04]), while he S shareholders yearly income ax rae is 39%. However, wih he Jobs and Growh Tax Relief Reconciliaion Ac of 2003, which cus he op ax rae on dividends from 35% o 5%, Hulse and Pope s argumen becomes weak. Plesko (995) explains he ax advanage of he S form for corporaions bearing losses. He argues ha immediae use of he loss o offse individual income ax paymens yields a higher presen value of ax savings han he C form, which has o carry losses forward o offse fuure profis in he corporaion. Also, if he shareholders personal ax rae is higher han he firms corporae income ax rae, losses passed hrough o he shareholders could offse a greaer amoun of ax liabiliy a he individual level han a he corporae level, even wihou presen value consideraions. 3

24 Despie he heoreical expecaion of ax advanages for he S form and policy makers inenions o favor small business by creaing he S form, no many corporaions ook he S form in he early 980s because here were a lo of ax loopholes shelering C corporaions income, which made he S form less aracive han he congressmen had desired. The Tax Reform Ac of 986 (TRA86) eliminaed a lo of loopholes ha allowed C corporaions o avoid CIT paymens and simulaed he expansion of he S form furher, making i more imporan in he economy. For example, TRA86 se up he Alernaive Minimum Tax (AMT), so ha corporaions could no longer avoid ax paymen hrough he ax shelers of deb financing and acceleraed depreciaion. The AMT calculaes axable income differenly han he CIT, adding back par of he benefi of acceleraed depreciaion and oher ax-reducing iems. Those oher ax-reducing iems include some ineres receips from ax-exemp municipal securiies and axes deferred by use of compleed conrac accouning. (The compleed conrac mehod allows a manufacurer o pospone reporing axable profis unil a producion conrac is compleed. Since conracs may span several years, his deferral can have a subsanial posiive ne presen value. [Brealey & Myers, 99, p. 732]) Then he AMT equals 20 percen of he AMT axable income. Because he AMT makes he corporaion income ax an effecive burden for corporaions, i made he S form more aracive. In 996, Congress believed ha increasing he maximum number of shareholders of an S corporaion will faciliae corporae ownership by addiional family members, employees and capial invesors (US Code 996, p. 59). Thus, i increased he maximum number of shareholders from 35 o 75 in he Small Business Job Proecion Ac. The law also removed barriers prevening banks from organizing as S corporaions. 4

25 5 According o Plesko (994), S corporaions accouned for less han 20% of all corporaions, less han 2% of all corporae asses, and abou 5% of corporae business receips prior o 986. In 989, hose percenages increased o 39% of corporaions, 3.9% of asses, and 3% of business receips. In 996, 58.2% of corporaions in he US were S corporaions, wih 8.6% of oal receips and 3.8% of oal asses. (Benne, 200). The prevalence of he S form and he difference of is ax reamen from ha of he C form provide a es of he dividend axaion heories. 2.4 Mehodology: Cos of Capial and C versus S Corporaions The mos prominen work summarizing he radiional and new views is done by Poerba and Summers (984). In order o apply heir framework in he C and S forms scenario, I reierae heir mahemaical derivaions briefly here. They se a profimaximizing firm s objecive funcion as maximizing he presen value of afer-personalincome-ax dividend income minus reinvesmen, = = 0 j N j j j V D z m z V Max ρ, subjec o four consrains: capial sock accumulaion, cash flow equaliy, minimum new share issues, and non-negaive dividends. Thus, hey se he Lagrange funcion as [ ] ( ) [ ] = ) ( N N N N D V V I D V K I K K V D z m z ξ η π τ μ λ ρ, where m = shareholder s effecive ax rae on dividend τ = effecive corporae income ax rae z = shareholder s accrual capial gain ax rae

26 ρ = shareholder s required rae of reurn D = dividend a ime. D 0 V N = new share issued a ime K = capial sock a ime I = capial invesmen a ime π( ) = preax profiabiliy funcion N V = minimum level of new share issues. V 0 when i is less han zero, i indicaes N N share repurchase. V V N μ, λ, η, and ξ = Lagrange mulipliers Holders of he radiional view believe ha dividends offer exra benefis such as signaling profiabiliy ha ouweigh heir ax disadvanages so ha corporaions disribue hem despie he double axaion. Therefore, shareholders required rae of reurn is a funcion of dividend payou raio α: = D ρ + ρ = ( τ ) π ρ ( α ) where ρ' < 0, which means he higher he dividend payou raio, he lower rae of reurn shareholders reques. Manipulaion of firs order condiions (as shown on page 2 of Poerba and Summers s paper) gives he user cos of capial under he radiional view: c = π '( K) = ρ ( τ )[ α( m) + ( α )( z) ] The mah formula of he user cos of capial shows ha dividends are doubly axed because boh he corporae income ax rae, τ, and he individual income ax rae, m, 6

27 appear in he denominaor. The double axaion of dividends increases he cos of capial in he corporae secor. Correspondingly, shareholders require ha he reurn from marginal invesmen be high enough o cover he ax loss from he double axaion. Thus, dividend axaion increases he cos of capial, lowers invesors incenive, and reduces corporae capial accumulaion, and herefore dividend axaion should be reformed hrough he inegraion of CIT and personal income ax. However, he holders of he new view believe ha dividends offer no exra benefis bu are only a means of disribuing profis o shareholders. Thus, he shareholders required rae of reurn is irrelevan o he dividend payou raio. Manipulaion of he firs order condiions wih he assumpions under he new view (as shown on page of Poerba and Summers s 984 paper) gives he user cos of capial under he new view: c = π '( K) = ρ τ ( )( z) The individual income ax rae, m, does no appear in he denominaor and dividends are axed only once if we ignore he negligible capial gain axaion. Therefore, he user cos of capial under he new view is lower han ha under he radiional view. The holders of he new view believe ha he old view exaggeraes he disorion; hey worry ha inegraing he corporae and personal income axes will significanly reduce governmen ax revenues wihou increasing he incenive o inves by much. No work has been done o relae he dispue beween he radiional and new views o he C versus S forms and o derive he cos of capial for S firms. The cos of capial for S corporaions can be easily derived using he same framework as Poerba and Summers (984). The maximizaion funcion for he S corporaion shareholders is 7

28 8 differen from ha for he C corporaion shareholders. Shareholders of S corporaions firms receive heir reurn o invesmen hrough dividends and appreciaed equiy value; however, no maer wha proporion of profi is disribued as dividends, all he profi is subjec o personal income ax. Because all he profi has been axed by he personal income ax, dividends are ax-free. However, when shareholders receive income by rading shares or by dissolving he corporaion, ha income is subjec o capial gain ax. Therefore, heir shareholders rae of reurn is ( ) N V V V V z V D + = + ρ, where V N denoes new share issues. And he capial asse value is + + = + N D z V V z V ρ. Solving he value equaion forward and assuming he ransversaliy condiion, 0 lim = + T T T V z ρ, we can ge he curren value = = 0 j N j j j V D z z V ρ. Maximizing he curren value subjec o four condiions capial accumulaion, cash flow equaliy, minimum new share issues requiremen, and minimum dividend disribuion requiremen, we have he Lagrange funcion: [ ] ( ) [ ] = ) ( N N N N D V V I D V K m I K K V D z z ξ η π μ λ ρ Using derivaion similar o he work of Poerba and Summers (984) as follows leads o he user cos of capial funcions under he new view and radiional view, respecively.

29 9 The same as he radiional view in he C corporaion scenario above, shareholders required rae of reurn is a funcion of he dividend payou raio α: ( ) ( ) ( ) K m D α ρ π ρ ρ = = +, where ρ' < 0, which means he higher he dividend payou raio, he lower he rae of reurn shareholders reques. In equilibrium, ρ = ρ +. Firs order condiions give he following equaions: I : = 0 + λ μ K : ( ) ( ) ( ) ( ) ( ) 0 ' ' ' = Ω z z m D m D K m z ρ π π π π ρ π μ λ ρ λ V N : = 0 μ η D : ( ) ( ) ( ) 0 ' = Ω z z m m D z ρ π π ρ ξ μ where [ ] ( ) [ ] ( ) N N N N D V V I D V K m I K K V D z ξ η π μ λ + = Ω ) ( The radiional view assumes corporaions will disribue oo many dividends despie he dividend ax and no accumulae enough inernal funds for new invesmen opporuniies; herefore, corporaions will have o issue new shares o finance new invesmens. Thus N N V V > which leads o = 0 η and = μ. Therefore, = λ which is

30 a consan and leads o λ = λ +. Also, because corporaions disribue dividends, D > 0 and hus ξ = 0. ( m) '( K ) Furher manipulaion of firs order condiion of K gives z D ρ+ ρ+ π + π '( K ) = +, ( z) π ( K ) z z where he las approximaion comes from Taylor s expansion. Thus, he user cos of capial under he radiional view is ρ c = π '( K) =. ( m)( z + αz) However, he holders of he new view believe ha dividends offer no exra benefis bu are only he means of disribuing profis o shareholders. The shareholders required rae of reurn is irrelevan o he dividend payou raio. The firs order condiions become I : K : V N : D : λ + μ = 0 λ + λ+ ρ + z μ η = 0 + μ ξ = 0 z μ ( m) π '( K ) = 0 As here is no non-ax benefi of dividends, maure corporaions hose whose reained earnings are enough o finance heir limied invesmen opporuniies always finance new invesmen hrough reained earnings and disribue he remaining profis o shareholders. Thus D > 0, which leads o ξ = 0 and λ = μ = z. Obviously, λ is 20

31 consan if accrual capial gain ax rae does no change and hus λ = λ +. Furher manipulaion of he firs order condiion of K gives ( m) π '( K ) = ρ + z ρ z, where he las approximaion comes from Taylor s expansion. Thus, he user cos of capial under he new view is c = π '( K ) = ρ ( m)( z). Table 2.: Comparison of Cos of Capial under Differen Views for Differen Forms Tradiional view New view c = π '( K) = c = π '( K) = C corporaions ρ ( τ )[ α( m) + ( α )( z) ] ρ ( τ )( z) c = π '( K) = c = π '( K S corporaions ) = ρ ( m)( z + αz) ρ ( m)( z) For ease of comparison, Table 2. pus ogeher he cos of capial under wo differen views for wo ypes of corporaions. For C corporaions, he cos of capial under he radiional view is higher han ha under he new view, as long as C corporaions pay dividends (i.e., α > 0); on he oher hand, for S corporaions, he cos of capial under he radiional view is lower han ha under he new view. Two reasons accoun for he difference. Firs, dividends o S corporaions shareholders are ax-free, bu capial gain is no. If S corporaions save excessive profis wihou disribuing hem, 2

32 shareholders will have o pay capial gain ax when hey eiher rade heir shares or liquidae he business. Second, under he radiional view, dividends disribuion provides more benefi han only ha of disribuing profis. This unmeasured benefi helps reduce he cos of capial. Therefore, he bes dividend policy for S corporaions under he radiional view is o disribue all he profis o shareholders and issue new shares o finance marginal invesmen. However, because he accrual capial gain ax rae is negligible, he cos of capial does no differ much from one view o he oher. Figure 2. illusraes demand and supply of corporaions capial sock if we can assume ha he marginal corporae income ax rae, he marginal individual income ax rae, and he capial gain rae are fixed. Figure 2.a illusraes he demand and supply for C corporaions. Curve ab represens he demand for capial; each poin on i sands for he marginal rae of reurn of he invesmen. Line cd represens he cos of capial under he radiional view and line ef represens he cos of capial under he new view. To maximize heir profis, corporaions keep invesing unil capial s rae of reurn equals he cos of financing. Obviously, under he radiional view, he double axaion of dividends imposes a larger dead weigh loss and reduces overall capial sock in he corporae secor. Similarly, Figure 2.b illusraes he demand and supply for S corporaions. The cos of capial under he radiional view, c'd', is lower han he cos of capial under he new view, e'f'. However hey are very close o each oher. 22

33 Cos of capial a c d Cos of new equiy issues (radiional view) e f Cos of financing wih reained earnings (new view) b Invesmen Figure 2.a: radiional versus new views under C corporaions scenario Cos of capial a e f c d Cos of financing wih reained earnings (new view) Cos of new equiy issues (radiional view) b Invesmen Figure 2.b: radiional versus new views under S corporaions scenario Figure 2.: Cos of Invesmen Financing 23

34 An imporan finding from able 2. is ha he dividend payou raio, α, appears in boh formulas for C and S corporaions under he radiional view; however, higher payou raios increase he cos of capial for C corporaions bu lower he cos of capial for S corporaions. Neverheless, α does no appear in boh cos formulas under he new view. If we ake i for graned ha invesors always choose o have he lowes cos of capial, his comparison of cos formulas provides a es on he wo views. If he radiional view is correc, hen S corporaions will disribue a significanly higher proporion of profis as dividends han C corporaions. However, if he new view is correc, hen dividend payou raio is irrelevan o he cos of capial and we canno observe any difference in dividend payou raio beween C and S corporaions. Thus, I se up my firs hypohesis: Hypohesis : S corporaions pay higher percenage of profi as dividend han C corporaions. OLS regressions of dividend payou raio on organizaional forms can direcly es his hypohesis. However, organizaional form may be endogenous o dividend payou raio because firms ha pay a higher proporion of heir profis as dividends migh selec he S form. An insrumenal variable for he organizaional form is necessary for unbiased esimaion. I will use each firm s average CIT rae in he preceding year as an insrumen. User cos of capial formulas in able 2. show ha under he radiional view or he new view, he cos of capial for S corporaions can be higher or lower han ha for C corporaions, depending on he corporae income ax rae τ and he personal income ax rae m. However, one hing is clear ha he higher he corporae income ax rae, τ, he more likely ha he cos of capial for C corporaions is higher han ha for S 24

35 corporaions. If he cos of capial for he C corporaions is higher han ha for he S corporaions, C corporaions will elec he S saus; oherwise, hey will remain in he C form. Thus I se up my second hypohesis: Hypohesis 2: A high average CIT rae causes corporaions o ake he S form. If hypohesis 2 is proven o be correc, hen I will use i as an insrumenal variable for organizaional forms and use insrumenal variable mehod o es hypohesis, presuming CIT rae is no relaed o dividend payou raio. 2.5 Daa I will use confidenial Georgia Tax Reurn daa provided by he Georgia Deparmen of Revenue. Corporaions ha own propery or do business in Georgia are subjec o he sae corporae income ax and ne worh ax. The Deparmen of Revenue uses shares of sale receips, propery values, and compensaion in Georgia o calculae he apporionmen raio, which deermines wha percenage of he naionwide corporae income is subjec o sae corporae income ax. (See Edmison [996] for a deailed descripion of he apporionmen formula.) Georgia also imposes a ne worh ax on he equiy of corporaions. For U.S. corporaions, all equiy in he Unied Saes is axed; however, for foreign corporaions, only he equiy in Georgia is axed. (See Grace [2002] for a descripion of he ne worh ax in Georgia.) C corporaions file he Georgia Form 600 Corporaion Tax Reurn, reporing federal axable income, sales receips, compensaion, propery value wihin Georgia and he Unied Saes, and equiy value. S corporaions file Georgia Form 600S Corporaion Tax Reurn. Even hough he IRS exemps S corporaions from federal corporae income ax, Georgia does no recognize he S saus. Therefore, insead of reporing federal axable income as C corporaions do, 25

36 S corporaions repor federal ordinary income, ogeher wih ne worh, sale receips, compensaion, and propery values in Form 600S. Unforunaely, he Georgia Deparmen of Revenue does no provide complee informaion regarding S corporaions, so I only know heir ordinary federal income and ne worh bu do no have informaion abou sales receips, compensaion, and propery values. My daase includes all he corporaions doing business in Georgia beween 990 and 999. The ax laws on CIT were relaively sable in his period. The ax reform acs in 993 and 997 did no make large changes in corporaion income axaion and made negligible changes in non-ax resricions on he conversion from C ino S. Therefore, invesors decisions on wha organizaional forms o elec were purely deermined by he ax raes, which change due o economic flucuaion and differen phases in he business cycles of individual firms. The ax daa does no provide he dividend payou raio direcly; however, i provides ne worh ax informaion. We can use he ne worh o find he dividend payou raio. The ne worh is defined as he sum of oal capial sock, paid in or capial surplus (i.e., shareholders overpaymen o he corporaion when hey purchase he shares), and reained earnings. The increase of ne worh from he previous year o he curren year is a good proxy of ne earnings reained in curren year; given ha corporaions earn profis in he curren year. Subsequenly, corporaions afer-ax profis minus he amoun of earnings reained are he paid-ou dividends, and dividends divided by he afer-ax profis give he dividend payou raio of ineres. The oher variables used in he analysis include equiy, before-ax earnings, and age. Because I needed wo consecuive years o 26

37 figure ou he dividend payou raio, I used he average equiy and average before-ax earnings in he wo years. An iniial check of he daase showed ha a porion of he C corporaions had foreign shareholders; a small number of corporaions filed boh 600 and 600S ax forms in he same year or swiched beween he forms more han once wihin five years; a fracional percenage of corporaions eiher had one year ax informaion missing or had several records in one single year. As he IRS does no allow S corporaions o have foreign shareholders and forbids corporaions o swich back and forh wihin five years, I excluded hose corporaions wih foreign shareholders and hose ha swiched several imes wihin five years. As I needed coninuous years informaion o derive he dividend, I excluded corporaions wih one ax year s record missing or wih several records for a single year. Afer he iniial daa-cleaning work, I made wo imporan adjusmens o fi he daa o my analyical framework. Firs, his paper sudies he dividend policy of comparable C and S corporaions and he conversion from he C form ino he S form. Ideally, I should screen all he C corporaions in he sample and filer ou hose C corporaions which do no mee he IRS requiremens for he S form saed in he earlier secion. However, here is no informaion abou he corporaions shareholders in he ax forms. Neverheless, I believe ha eligible C corporaions (even hough hey did no conver ino he S form) should have an equiy size similar o hose S corporaions, because C corporaions wih oo large a size usually have oo many shareholders and are no eligible o conver ino he S form. Therefore, I limied my pool of C corporaions o hose whose equiy size does no exceed $5,774,859, he 99h percenile of equiy size of 27

38 S corporaions. The reason ha I do no se he crierion o be he maximum equiy size of S corporaions is ha corporaions wih he maximum equiy migh be an ouliers due o inpuing errors. Second, he heoreical discussion in his paper focuses on profi-making corporaions. However, he S form is also aracive o invesors in loss-bearing corporaions because S shareholders can use he loss o offse heir individual income, whereas C shareholders canno (Plesko, 995). Furhermore, his paper ess he heories on dividend axaion, which concerns how corporaions deal wih profis raher han losses. Therefore, he regression is limied o corporaions wih posiive ne earnings. Table 2.2 liss he means and sandard deviaions of variables in he final sample. There are over en imes as many S corporaions as C corporaions in he sample, which indicaes ha he S form dominaes among small corporaions. Apparenly, C corporaions on average disribue 33% of heir profis as dividends compared wih he 67% dividend payou raio among S corporaions. Also, C corporaions have larger equiy size, earn more profis, and have a lile longer hisory han S corporaions. However, he sandard deviaions of hose variables are very large, indicaing large variaion among each group. Table 2.2: Mean and Sandard Deviaion of Variables in he Sample N dividend payou raio equiy ($K) profis ($K) age (year) average CIT rae C corporaions % % (34%) (535) (776) (9) (20%) S corporaions % (33%) (568) (388) (8). Noe: Sandard deviaions are in he parenheses. 28

39 2.6 Findings: Dividend Payou Raio and C versus S Forms The difference beween C and S forms provides a good chance o examine he validiy of he differen views. If he new view and he nucleus heory are correc hen corporaions will always finance heir new invesmen hrough reained earnings as long as he CIT rae is lower han he personal income ax rae; dividend payou is he residual of ne earnings subrac reained earnings and is paid ou regardless of he ax cos. Therefore, here should be no significan difference in dividend payou across he forms. On he oher hand, if he radiional view is correc, hen we should observe a higher payou raio for S corporaions han C corporaions. I used OLS regression o es he radiional versus he new view. The regression akes he following form: Div _ raio β + β S _ dummy + β ln( Equiy) + β ln( Earning + β Age = ) 4 where Div_raio sands for he dividend payou raio. I ook he log ransformaion of boh equiy and earning in order o downsize heir scales and normalize hem. Anoher benefi of log ransformaion is ha i makes he explanaion of he coefficiens more sensible in ha he coefficiens show he change of dividend payou raio in erms of percenage poins in response o percenage change of equiy and earnings. Depending on he informaion available in my sample, he oher conrol variables include age, he log funcion of wo years average of equiy, and he log funcion of wo years average of before-ax ne earnings. I expeced age o have a posiive impac on dividend payou raio because maure firms have limied invesmen opporuniies and are more likely o disribue ne earnings as dividends. I expeced before-ax ne earnings o 29

40 have a posiive effec on dividend payou raio because he remaining ne earnings minus furher invesmen over ne earnings is an increasing funcion of ne earnings. The impac of equiy is expeced o be negaive because large corporaions are expeced o have more invesmen opporuniies and will reain more profis. There are hree regression models on hree differen samples. The firs regression analyzes he dividend payou raio difference before and afer a C corporaion convered ino he S form. For example, assume a corporaion exiss in periods one hrough six. I elecs C saus in periods one hrough hree and changes o S saus in period four and remains here hrough period six. I use he ax informaion in periods one and wo o calculae he dividend payou raio before conversion and he informaion in periods five and six for he payou raio afer conversion. I do no use informaion in periods hree and four because ax informaion in ransiion periods migh no be reliable. Similarly, he second regression analyzes he difference before and afer an S corporaion convered ino he C form. The hird one makes horizonal comparisons on C and S corporaions in he same year o see if S corporaions disribue a higher porion of profis han comparable C corporaions, given heir size, earning and age conrolled. I ran he regressions on corporaions which have posiive earnings and disribue no more han heir oal ne earnings. There are a few corporaions disribuing dividend despie negaive ne earnings or decreasing equiy despie posiive ne earnings. However, hese firms are irrelevan o he sudy of he relaionship beween organizaional forms and dividend policy because according o IRS rules, disribuion in case of loss in he curren year and exra disribuion exceeding curren year earnings are reaed as reurn of capial which is no axed (Scholes e al. 2005, p. 352). Therefore, I exclude hem 30

41 from he sample. Table 2.3 summarizes he regression resuls. Models and 2 make verical comparisons of he dividend payou raio before and afer he conversion. Model is for hose C corporaions which convered ino he S form and model 2 is for hose S corporaions which convered ino he C form. Model 3 makes a horizonal comparison of dividend payou raio among comparable C and S corporaions. Model 4 also makes horizonal comparisons, as model 3 does, bu adds addiional year dummy variables in he regression in an aemp o conrol he specific ime effec of each year, using 998 as he conrol year. However, hose yearly dummy variables hardly add any more informaion in he explanaion of corporaions dividend payou raio as he R square does no increase in model 4 and here is lile difference beween coefficiens in model 3 and model 4. Across he models, he coefficien of he S saus dummy variable is significanly posiive, which suggess ha S corporaions pay ou a higher proporion of profis as dividend han C corporaions. As shown in model, afer hose C corporaions conver ino he S form, hey pay 30.7% more of heir profis as dividends han hey did before he conversion. Similarly, model 2 shows ha afer hose S corporaions conver ino he C form, hey pay 24.0% less of heir profis as dividends han hey did before he conversion. The coefficien of he S dummy in model 3 is inerpreed as showing ha S corporaions are expeced o disribue 23.0% more of heir profis han comparable C corporaions. These resuls conform o he predicion of radiional view ha dividend paymen is influenced by he cos of dividend ax. 3