The Informativeness of Dividends and Associated Tax Credits

• Author: Stephen L. Taylor,Caitlin M. S. Ruddock,Jeffrey J. Coulton
• DOI: http://doi.org/10.1111/jbfa.12095
• Date: 01 November 2014
• Published date: 01 November 2014

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(9) & (10), 1309–1336, November/December 2014, 0306-686X

doi: 10.1111/jbfa.12095

The Informativeness of Dividends and

Associated Tax Credits

JEFFREY J. COULTON,CAITLIN M. S. RUDDOCK AND STEPHEN L. TAYLOR∗

Abstract: This paper investigates the informativeness of dividends and the associated tax

credits with respect to earnings persistence. After confirming that dividend-paying firms have

more persistent earnings than non-dividend-paying firms, we show that the taxation status of

the dividend is also important. Firms that pay dividends with a full tax credit attached have

significantly more persistent earnings than firms that pay dividends which carry no associated

tax credit. Consistent with higher levels of tax credits identifying more mature firms, those

paying dividends with full tax credits have significantly less persistent losses than firms that pay

dividends with only partial tax credits. Further,market pricing tests confirm that the incremental

information in dividends and tax credits contributes to reductions in market mispricing of the

persistence of earnings and earnings components. Our results are robust to alternative model

specifications and controlling for dividend size and firm age.

Keywords: earnings persistence, dividends, tax credits, franking

1. INTRODUCTION

We investigate whether two simple indicators, dividends and dividend-related tax

credits, provide users with information that helps assess earnings quality. Specifically,

we examine whether dividends and higher levels of tax credits indicate higher earnings

persistence. Persistence is an important attribute of earnings (Dechow and Schrand,

2004; Hanlon, 2005). A persistent earnings series is more readily useable as a short

cut to valuation (e.g., via multiples; Penman, 1991; Schipper and Vincent, 2003).

Persistent earnings are also a better predictor of future earnings (Sloan, 1996).

Our persistence tests are further supplemented with market pricing tests that assess

whether dividend and tax credit information impact on the efficiency with which

investors price the persistence of earnings and earnings components.

Our analysis is motivated by the relative absence of empirical evidence that directly

demonstrates a signalling role for dividends. Baker and Wurgler (2012) argue that

while surveys suggest that managers view dividends as an important signal for investors

∗The first author is from the School of Accounting, UNSW Australia Sydney, New South Wales, Australia.

The second author is from the School of Accounting, University of Technology, Sydney, New South Wales,

Australia. The third author is from UBS Global Asset Management (Australia) Limited, Sydney, New South

Wales, Australia.

Address for correspondence: Dr. Jeffrey J. Coulton, School of Accounting, UNSW Australia, Sydney, New

South Wales, Australia 2052.

e-mail: j.coulton@unsw.edu.au

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1310 COULTON, RUDDOCK AND TAYLOR

(Brav et al., 2005), there is remarkably little empirical evidence of how this occurs.

Further, many of the economic mechanisms that underlie well-known signalling

models, such as the costs that can be borne in raising external funds or the ability

to bear costly taxes, are explicitly ruled out by the same survey evidence used to cite

managerial support attributing a signalling role for dividends. In contrast, we identify

a link between an existing theory of dividends (the life-cycle theory) and earnings

attributes such that dividends and their tax status are expected to serve as a signal of

earnings persistence.

We draw on an environment (Australia) that is particularly appropriate for investi-

gating these issues. For the period we examine, Australia has had a taxation system that

eliminates double taxation on dividends by providing shareholders with an attached

entitlement to a tax credit for dividend income received on which company tax has

already been paid. This setting has the added advantage of introducing a second

dividend-related signal, namely its tax status (i.e., the extent to which a tax credit

is attached). We therefore consider both the dividend-paying status of the firm, as

well as the tax status of the dividend. Australian earnings also have lower levels of

persistence compared to the US, due in part to the higher frequency of losses (Coulton

et al., 2005). Hayn (1995) shows that losses reduce the informativeness of earnings.

Given the increasing frequency and persistence of losses in Australia and elsewhere,

it is important to explicitly consider losses in explaining the low level of earnings

persistence (Hayn, 1995; Balkrishna et al., 2007). Hence, we also explicitly examine

how dividend-paying status (and the tax status of the dividend) informs assessment of

loss persistence.

Our research makes a number of contributions that are likely to be of interest to

investors, policymakers and academics. First, similar to Skinner and Soltes (2011),

we identify circumstances in which earnings are more persistent. Second, we provide

evidence on whether dividends and the associated tax credits increase the informa-

tiveness of profits, losses and accruals. Third, our tests show that the information in

dividends and tax credits helps investors correctly price the persistence of earnings

components. This is particularly important as the failure by investors to correctly price

the persistence of earnings and its components can lead to mispricing (Sloan, 1996).

Fourth, our study also contributes more broadly to the existing literature on the impact

of taxation regimes on dividends and their informativeness (Baker et al., 2012; Li,

2014).

Dividend-paying firms have different characteristics to firms that do not pay

dividends (Fama and French, 2001; Hand and Landsman, 2005; DeAngelo et al.,

2006). DeAngelo and DeAngelo’s (2006) full payout model lends itself to dividend

payments corresponding to the different stages in the firm life cycle.1As firms mature,

becoming more profitable and self-funding, they are more likely to pay dividends. Firm

characteristics such as profitability and low growth options associated with dividend

payments are also likely to drive earnings persistence. Hence, we expect to observe

a positive association between dividend payments and earnings persistence. Our

approach contrasts with much of the dividend signalling literature, which focuses

on the implications of dividend changes, and which yields mixed results. On the

other hand, survey evidence (Brav et al., 2005) suggests that managers are primarily

1 Similar results supporting a life-cycle theory have been reported for Australian firms (Coulton and

Ruddock, 2011).

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