Dividend payout ratio, tax rates, and share repurchase

This paper examines whether the legalization of share repurchase in 1982 by the U.S. Securities and Exchange Commission had a significant impact on the relationship between dividend payout and dividend tax preference, which measures tax rates on dividends relative to tax rates on capital gains. A bi-variate time series model of dividend and dividend tax preference is employed in which the dividend payout ratio relates to the mean of dividend tax preference, which follows a three-state Markov regime switching process, and depends upon the legitimacy of share repurchase. For the period covering 1929-2011, which covers multiple large changes in tax rates, we find that stock buybacks have a significant impact on the relationship in the high mean regime of dividend tax preference. This result suggests that share repurchases are a close substitute for cash dividends.