The Lock-In Effect and the Corporate Payout Puzzle

Out of their after-tax profits, corporations pay dividends and often repurchase shares to generate capital gains for their shareholders. Capital gains typically attract lower effective rates of tax than dividends, which leads to the payout puzzle: Why do corporations continue to pay dividends in spite of their relative tax disadvantage? This paper develops a model of corporate payout policy to explain some aspects of the puzzle. The key element of the model is the lock-in effect caused by the fact that capital gains are taxed only upon realization, which implies that taxpayers can reduce the effective rate of tax by postponing realizations, i.e., by locking in accrued capital gains. Shareholders with an accrued capital gain, thus, would require a lock-in premium to compensate them for their higher tax liability resulting from the sale. This premium is an increasing function of accrued capital gains and the desired holding period for equity. In this setting firms pay dividends in equilibrium whenever the lock-in premium is high relative to the tax disadvantage of dividend payments. It follows that firms with a relatively high proportion of shareholders with sizable capital gains and/or long holding periods face higher repurchasing costs and are thus more likely to pay dividends. The model predicts that total payout increases as the capital gains tax and the profits tax increase, whereas the dividend tax has no effect. The model’s predictions are examined empirically using data from a panel of Canadian corporations listed on the TSX over the period 1987-2008. The empirical results, being largely consistent with those of the model, are encouraging. ∗First I would like to thank my advisor Kul Bhatia for his invaluable insights and support over the last three years. I would also like to thank Jim Davies for numerous comments and suggestions pertaining to this paper. Peter Streufert also deserves thanks for a number of helpful discussions regarding the theoretical section. Last I would like to thank Mike McCausland for providing detailed comments on an earlier draft.