The Interaction of Corporate Dividend Policy and Capital Structure Decisions Under Differential Tax Regimes

Abstract

We develop a valuation model that integrates corporate capital structure and dividend payout policies. The resulting extended Miller (1977) model explicitly incorporates the different tax rates on corporate income, personal interest, dividends, and capital gains. We apply the model to ten different U.S. tax regimes since 1979 and generate several testable predictions. When the dividend tax rate exceeds the capital gains tax rate, dividend payout can partially offset value enhancing effects of leverage. When the two rates are close, dividend payout loses its moderating influence. Using the S&P 1500 universe, we obtain empirical results that are consistent with the model's predictions.

Keywords: Capital structure, Dividend policy, Tax rates

JEL Classification: G32, G35, H24, H25