If capital gains are taxed at more attractive rates than dividends, which has been the case often in the U. S., dividends are an inferior way for shareholders to receive returns.
Under current U.S. tax laws, dividends and capital gains are taxed almost equally. But if capital gains are taxed favorably to dividends, as they have been at times in the past, companies could want to keep their dividends down.
Even under equal taxation of dividends and capital gains, dividends can be taxed unfavorably to capital gains. Capital gains taxes can be deferred by selling at a later date. Indeed, investors can decide when to sell stocks and incur capital gains taxes. Investors have no control over the receipt of dividends. Some capital gains taxes can even be deferred indefinitely by donating the stock to a non-profit organization. Also, if the stockholder dies, the accumulated capital gains taxes go away, because the heirs are taxed only on the accumulated capital gains after they acquire the stock.
The only requirement for a stock to qualify for capital gains taxes is that it be held at least one year. This is not a particularly onerous requirement. There are, however, some limits to the tax deductibility of capital gains. Capital losses offset capital gains, and only the net is taxed. If losses exceed gains, only $3,000 per year can be applied to other income. The remainder must be carried forward to reduce future gains and is therefore worth somewhat less as a tax credit.
Thus, it will nearly always be the case that capital gains will be preferred over dividends by shareholders. This point is consistent with the fact that most firms pay far lower dividends than they could, although it may not be the only reason why.
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Last updated: January 9, 2011