Retention and Tax Avoidance : A Clarification

The modest title chosen by the editor understates the contribution of this paper. To the best of our knowledge, we were the first to use company-based shareholder valuation approach to refute the prevailing view that retention of corporate earnings under the U.S. tax system automatically decreases shareholders' tax burden by replacing the impact of dividend tax with that of capital gains tax - the latter being subject to beneficial deferment and often at a lower rate. We argue that rational investors view the current stock price as a discounted value of future cash flows after tax; any price appreciation due to retention reflects an expected increase in future dividends net of future dividend tax. Absent predictable changes in tax rates, any incremental payment of capital gains tax - due to share trading among investors at the appreciated price - is added to the impact of dividend tax, not substituted for it. This argument is independent of the firm's choice of distribution method. Our analysis of the corporation and its shareholders traces the common misconception regarding the tax impact of retention to three errors: (1) Disregard for the firm's optimal investment policy, (2) confusion between the timing and method of distribution, and (3) failure to distinguish between this year's tax exposure and the value of all future tax payments or, more generally, the net-of-tax value of all future distributions. Lamentably, thirty years after this paper's first presented, these conceptual errors are still welcome as legitimate hypotheses.[An earlier draft of this paper was presented in May 1978 at the Vincent C. Ross Institute for Accounting Research of New York University and circulated as GSBA Working Paper No. 78-137 (1978)]