Adoption of Dividend Imputation System and Its Impact on the
Degree of Financial Constraints of Firms – Evidence from Taiwan
Stock Market
Chau-Chen Yang
National Taiwan University
Cheng Few Lee
Rutgers University
Suming Lin
National Taiwan University
Sheng-Syan Chen
National Taiwan University
Abstract
This paper aims to investigate the impacts of the adoption of dividend imputation
system by Taiwan government on Taiwanese firms’ financing constraints. The
dividend imputation system adopted in Taiwan since 1998 was set up to resolve the
double-taxation problem faced by Taiwanese firms. According to the system, the
corporate income tax paid by the firms can be regarded as a deduction to the personal
income tax when shareholders receive dividends. Hence, shareholders pay only either
the corporate tax rate or the personal income tax rate on dividends, depending on
which is higher. Adoption of dividend imputation system will enable the shareholders’
after-personal-income-tax dividend income be greater than before even if firms’
profits do not increase. Hence, the shareholders’ wealth will be higher than before.
The implication is that firms will be willing to payout more dividends than before. If
firms pay out dividends in cash, they may encounter the problem of financing
constraints, since firms tend to use internal source of funds to finance their
investments. For those firms who remain paying out a great percentage of dividends
in stock may not encounter the financing constraints problem, since their dividend
decision haslittle to do with cash. It will be interesting to find out whether the
adoption of dividend imputation has impacts on the degree of financing constraints for
Taiwanese listed firms in the OTC as well as in the Exchange.
Firms listed in the OTC are mostly medium and small firms, while firms listed in
the Taiwan Stock Exchange are mostly large firms. Medium and small firms are
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usually high-growth firms and tend to have difficulties in financing externally. Larger
firms have stable performance record and good reputation, and have better access to
external financing. Hence, it is also interesting to test whether the impacts of dividend
imputation on the degree of financing constraints will be different for the OTC firms
and the Exchange firms. Though the debate on whether the cash flow sensitivity in the
traditional Q model can be employed as the degree of financing constraint or not is
still going on, we follow the Fazzari-Hubbers-Peterson’s (1988) argument in this
research.
Key research points:
1. What is the role (personal and corporate ) income tax rates plays in
determining the degree of financing constraints?
2. How can the Dividend Imputation System have impacts on firms’ degree of
financing constraints? (The rationale?)
3. What kind of firms will not be affected?(Low corporate income tax rates
firms?)
I. Introduction
This paper aims to investigate the impacts of the dividend imputation on Taiwanese
firms’ financing constraints. The dividend imputation system adopted by Taiwanese
government since 1998 was set up to resolve the double-taxation problem faced by
Taiwanese firms. Prior to 1998, shareholders who received dividends from Taiwanese
firms suffered the double-taxation problem. Firms’ after-tax profits allocated to their
shareholders would be regarded as one of their income items and taxed again. For
firms with maximum corporate income tax rate of 25% and shareholders with
maximum personal income tax rate of 40%, the real income tax burden for
shareholders is 55%. This will definitely hamper the willingness of investors to pour
more money to profitable companies.
After the adoption of dividend imputation system, we expect the double-taxation
problem to be alleviated. Firms and investors will be willing to invest more in the new
profitable production lines or companies. The after-personal-income-tax dividend
income will be greater than before even if firms’ profits do not increase. Hence, the
shareholders’ wealth will be higher than before. The implication is that firms will be
willing to payout more dividends than before.
If firms pay out dividends in cash, they may encounter the problem of financing
constraints, since firms tend to use internal source of funds to finance their
investments. It will be interesting to find out whether the adoption of dividend
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imputation has impacts on the degree of financing constraints for Taiwanese listed
firms in the OTC as well as in the Exchange.
For those firms who remain paying out stock dividends may not encounter the
financing constraints problem, since their dividend decision has nothing to do with
cash. This implication will also be tested as well. Unlike the dividend payout behavior
of firms in the developed countries, Taiwanese firms prefer stock dividends to cash
dividends. That is because local investors (shareholders) believe the
ex-stock-dividend price of shares tends to recover to their pre-ex-dividend period very
soon. For example, if a firm pays stock dividend of 20%, the investors of this stock
will expect the ex-dividend stock price to shoot up 20% in a short period. This is an
unique interesting phenomenon in Taiwan stock market.
Firms listed in the OTC are mostly medium and small firms, while firms listed in the
Taiwan Stock Exchange are mostly large firms. Medium and small firms are usually
high growth firms and tend to have difficulties in financing externally. Larger firms
have stable performance record and good reputation, and have better access to
external financing. Hence, it is also interesting to test whether the impacts of dividend
imputation on the degree of financing constraints will be different for the OTC firms
and the Exchange firms.
Black, Legoria, and Sellers (2000) studied the impact of adoption of the
dividend imputation system by New Zealand and Australia on firm’s financing
constraints. They indicated, in 1992, the U.S. Treasury proposed the elimination of the
double tax on corporate dividends as a means of reducing the perceived bias against
investment in the corporate sector. In 1987, New Zealand adopted dividend
imputation and significantly lowed corporate taxes to eliminate the double tax on
corporate dividends while stimulating economic growth. In 1987, Australia adopted a
dividend imputation system similar to New Zealand’s, while imposing a capital gain
tax on sales of stocks in the meantime. Major purposes of their paper include the
determination of the effects of dividend imputation on capital investment and the
investigation of whether the effects will differ for New Zealand and Australia. They
divided the samples into two groups: high- and low-dividend portfolios and test the
separate effects of dividend imputation and capital gains tax on capital investment.
II. Purposes of this paper:
(1) To investigate whether the adoption of dividend imputation in 1998 has
impact on the capital investments and the degree of financial constraints of listed
firms in Taiwan?
A slope dummy regression approach will be used to examine the difference of the
3
regression coefficients before and after the dividend imputation.
(
I
)it  ai  biQit  ci D  Qit  eit
K
(
I
CF
CF
)it  ai  biQit  ci D  Qit  d i (
)it  ei D  (
)it  eit
K
K
K
(
WC
CF
) it  ai  bQit  c(
) it  eit
K
K
(
WC
CF
CF
)it  ai  bQit  ci D  Qit  d i (
)it  ei D  (
)it  eit
K
K
K
(2) Whether the results in (1) will be different for the OTC firms and the TAIEX
firms?
(3) Whether the results in (1) will be different for the China-concept firms and
non- China-concept firms?
(4)How will the actual corporate tax rate (c) play an important role in this
research?
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