Tax Effect

An assumption of the MM hypothesis is that there are no taxes. In implies that retention of earnings (internal financing) and payment of dividends (external financing) are, from the viewpoint of tax treatment, on an equal footing. The investors would find both forms of financing equally desirable. The tax liability of the investors, broadly speaking, is of two types: (i) tax on dividend income, and (ii) capital gains. While the first type of tax is payable by the investors when the finn pays dividends, the capital gains tax is related to retention of earnings. From an operational viewpoint, capital gains tax is (i) lower than the tax on dividend, (ii) it becomes payable only when shares are actually sold, that is, it is a tax the actual sale of the shares. The types of taxes corresponding to the two forms of financing are different, although the MM position would imply otherwise. The different tax treatment of dividend and capital gains means that with the retention of earnings the shareholders tax liability would be lower or there would be tax saving for the shareholders. For example, a firm pays dividends to the shareholders out of the retained eamings. To finance its investment programmes, it issues rights shares. The shareholders would have to pay tax on the dividend income al rates appropriate to their income bracket. Subsequently, they would purchase the shares of the firm. Clearly the tax could have been avoided if, instead of paying dividend, the earnings were retained. If, however, the investors required funds, they could sell a part of their investments, in which case they will pay tax (capital gains) at a lower rate. There is a definite advantage to the investors owing to the tax differential in dividend and capital gains tax and, therefore, they can be expected to prefer retention of earnings. This line of reasoning is also supported by empirical evidence. Elton and Gruber have shown that investors in high income brackets have a preference for capital gains over dividends while those in low tax brackets favour dividends. In a more comprehensive study Brittain? found an inverse relationship between dividend payout ratios and the differential between tax rates on dividend income and capital gains. That is, rising tax rates tend to depress dividends. In brief, the investors are not, from the viewpoint of taxes, indifferent between dividends and retained earnings. The MM assumption is, therefore, untenable.

With effect from financial year 2002-3, dividend income from Indian corporate firms, and mutual funds is exempt from tax upto Rs 12,000.

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