iBusiness, 2013, 5, 184-188
Published Online December 2013 (http://www.scirp.org/journal/ib)
Open Access IB
Tax Shield and Its Impact on Corporate Dividend Policy:
Evidence from Pakistani Stock Market
Akhlaq ul Hassan1, Mubashar Tanveer2, Muhammad Siddique3, Muhammad Mudasar4
1I-Mtas College Sinllanwali, Sargodha, Pakistan; 2University of Sargodha, Sargodha, Pakistan; 3Universiti Teknologi Malaysia, Johor
Bahru, Malaysia; 4Govt College of Commerce Shahpur Sadar, Sargodha, Pakistan.
Email: akhlaq_h@yahoo.com
Received July 5th, 2013; revised August 5th, 2013; accepted September 5th, 2013
Copyright © 2013 Akhlaq ul Hassan et al. This is an open access article distributed under the Creative Commons Attribution License,
which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.
The problem: what is the taxation impact on dividend policy? While much optimal taxation research focuses on the e-
conomic effects of taxation, the purpose of this study is to add a new dimension by investigating the relationship be-
tween taxation and payout ratio and some other variables of dividend policy. These relations are tested using the data
from financial statements of KSE listed companies. The results show that tax shield has no significant relation to the
dividend payout ratio but mostly dividend policy is due to the size of the firm and its profitability.
Keywords: Dividend Policy; Tax Shield; Determinant’s of Dividends
1. Introduction
A snowy debate in finance and public economics litera-
tures about the role of taxation in corporate dividend
policies is there. Taxes and dividend policy are the one of
the very important topics of corporate finance, as well as
for the Pakistani stock market. A lot of arguments re-
garding taxes and dividend policy have attracted many
educational researchers. Dividends, since the days of Mil-
ler and Modigliani, have been a topic of extensive re-
search in academia and the debate between practitioners.
Dividends provide “recompense” in a sense to investors
who have taken a menace by investing in the stock of a
certain company. Income that is earned by the company is
distributed to shareholders, and repeatedly increases over
time. They are normally paid on a regular basis, such as
quarterly. Companies that have a record of paying divi-
dends are usually traded at a first-class versus those that
do not. Investors in the company are thus provided cash
flow without having to sell shares; therefore, traditionally,
companies paying relatively high dividends have been
purchased by those on a fixed income. Manager’s base
current dividend levels of past dividend levels and current
earnings and imagine dividends are steady over time [1].
On the other side, some theories have conservative opin-
ion that dividend policy is applicable due to the exist-
ence of differential taxes in the market [2] (Poterba and
Summers, 1984; Ang et al., [3,4]). Others disagree that
“Clientele Effects” matter in dividend policy decisions
(Pettit, 1977; Scholz, 1992). It is because investors’ pref-
erences divide them in groups that tend them to select a
company where their investment goals and dividend pol-
icy are associated. Signaling models focus on allaying the
information asymmetries. The former known as “Signal-
ing” theory, assumes that the dividend is one of the
sources through which a company can suggest informa-
tion to the market (Bhattacharya, 1979; [5,6]). According
to this theory, the dividend can moderate information
asymmetries between managers and shareholders by
conveying inside information of a firm’s future prospects.
The latter, known as “Agency” theory, argues that the
dividend reduces the costs of shareholder-manager con-
flict and it performs a controlling function where moni-
toring of a firm’s management by its Shareholders is in-
active [7]; Easterbrook, in 1984, [8] argues that by paying
dividends the flexible resources under managerial control
can be decreased and in this way the over investment
difficulty can be determined. Actual company earnings
are another key determinant of dividend payouts. There is
a statistically significant relationship between dividends
and earnings [9,10] (Hsu, Wang, & Wu, 1998; Lintner,
1956). Bhattacharya (1979), Miller and Rock (1985) [11]
show that adjustments in dividend payments are con-
nected to changes in earnings. A relationship between
dividends and earnings is also reported in other studies
Tax Shield and Its Impact on Corporate Dividend Policy: Evidence from Pakistani Stock Market 185
[12,13] (Watts, 1973, Gonedes, 1978, Lee & Kau, 1987).
Analyzing time series and cross-sectional data, Fama
shows that dividends and earnings are extremely corre-
lated. However, a survey with 384 financial executives
conducted by Brava, et al. (2005) shows that the connec-
tion between earnings and dividends has weakened the
market debt to capital ratio which is another possible
explanation of the variability in dividend payments. Sev-
eral papers have found a negative relationship between
leverage and dividend payout ratios. This negative rela-
tionship is plausible due to the extent that debts and divi-
dends are substitutes employed by managers to mitigate
agency conflicts or asymmetric information problems,
and this implies that an increased market debt to capital
ratio reduces dividend payout rates and vice versa. The
objective of this study is to assess the effect of tax shield
on the dividend policies in the KSE listed companies of
Pakistan. This study will also evaluate the role of taxes to
establish the dividend policies of the corporate sectors.
This study has the capacity to be helpful to policy makers
to better recognize how taxes impact dividend policies and
they will be in a better position to develop dividend poli-
cies by keeping in view of the influence of taxes. Before
conducting this study, our expectation was that tax saving
would directly go to the shareholders of the company.
2. Literature Review
[14] suggested in their study that before- and after-tax
returns to capital cannot be precisely estranged from the
tax system. They emphasized that in the best dividend
payout behavior, one cannot be separated away from
equilibrium concern and the analysis of the effect of
taxation on business valuation. [15] proposed that due to
the impediment in personal tax advantage of dividend, the
shareholder greatly prefers to invest in real assets to use
internal financing as compared to external. The profit-
ability of internally financed security investment is de-
pendent on the tax status of security and also the tax
bracket of shareholder. In contrast, externally-financed
security purchases are making loss from a tax stand point.
[16] evaluated the tax effect on dividend policy of Nige-
rian banks and proposed in their study that various factors
influenced the dividend pattern of companies. Due to the
accessibility of the profit, the dividend policy of the banks
is to frequently sustain a low but constant payout. The
most important factor of the dividend structure is the
liquidity position of the company. Dividend clients are a
very alarming aspect in the concern of a dividend policy.
[17] identified the signaling equilibrium with taxable
dividends in their theory. They described in their theory
that the employees of the organization, with more essen-
tial and confidential information, best allocate larger
dividends and obtain higher prices for their stock when-
ever firms have a demand of cash; thus, its existing
stockholders exceed its internal supply of cash. Green et.
al. (1993) questioned the irrelevance argument and in-
vestigated the relationship between the dividends and
investment and financing decisions. Their study showed
that dividend payout levels are not totally decided after a
firm’s investment and financing decisions have been
made. Dividend decision is taken along with investment
and financing decisions. The results however do not
support the views of Miller and Modigliani (1961) [18].
Partington (1983) revealed that firms’ use target payout
ratios, firms’ motives for paying dividends and extent to
which dividends are determined are independent of in-
vestment policy. [19] indicates a direct link between
growth and financing needs: rapidly growing firms have
external financing needs because working capital needs
normally exceed the incremental cash flows from new
sales. Higgins (1972) shows that payout ratios are nega-
tively related to firms’ need top fund finance growth op-
portunities. Rozeff (1982), Lloyd et al. (1985) and Collins
et al. (1996) all show significantly negative relationship
between historical sales growth and dividend payout. D,
Souza (1999) however shows a positive but insignificant
relationship in the case of growth and negative but insig-
nificant relationship in case of market to book value. In
the seminal work on dividends and company’s’ maturity,
Grullon et al. (2002) analyzed listed companies of New
York (NYSE) and American (AMEX) stock exchanges
between 1967 and 1993. They argued that company that
increases dividends experience a significant decline in
their systematic risk and such companies do not increase
their capital expenditure and experience a decline in
profitability in the years after the change in dividends.
They proposed an alternative explanation of Jensens’s
(1986) free cash flow hypothesis known as “Maturity
Hypothesis”. According to them in growing stage a com-
pany has many positive NPV projects and it earns large
economic profits with high level of capital expenditure.
Such companies are left with low free cash flows and
experience rapid growth in their earnings. But as a com-
pany continues to grow due to market competition, its
share price is cannibalized which reduces its profits. In
this transition phase, the company’s investment opportu-
nities begins to shrink and pace of its growth becomes
slow, hence company starts generating larger amount of
free cash flows. Ultimately it enters into maturity phase in
which the return on investment is close to the cost of
capital and its cash free cash flows are high. These mature
companies are now able to pay higher dividends. Ahmed
and Javid [20] proposed in their study that whenever the
non-financial companies of Pakistan quoted on Karachi
Stock Exchange set their dividend payments, these firms
consider the existing earning per share and past dividend
patterns. But, the tendency of dividend should be more
responsive to current earnings than previous dividends.
The listed non-financial companies having high momen-
Open Access IB
Tax Shield and Its Impact on Corporate Dividend Policy: Evidence from Pakistani Stock Market
Open Access IB
tum of modification and low target payout ratio, show
instability in smoothing their dividend payments. It is
evident from existing literature that very few researchers
have analyzed the relationship of tax shield and dividend
policy. Although, many researchers have used taxation
and dividend policy, but to the best of authors’ knowledge,
none of the researchers have analyzed the nature of the
relationship between tax shield and dividend policy in
Pakistan. The main objective of present study is to analyze,
using a non-linear model specification, whether mature
companies pay more dividends or not?
3. Objective & Expectation
The objective of this study was to find out the relationship
between the tax shield and dividend payout ratio and
expectation was that tax shield would impact the posi-
tively on dividend payout policy.
4. Data Collection & Methodology
For present study a sample penal data of 33 companies
listed at Karachi Stock Exchange (KSE) has been col-
lected for the period of six years i.e. from 2005-2010.
Companies were listed at KSE during years 2005 to 2010.
Should not be a State Owned Enterprise. Panel regression
is among the widely used technique to investigate the
impact of firm specific characteristics on dividend We
have used the same estimation technique to analyze the im
pact of ownership structures and cash flow characters on
dividend behavior of companies listed in KSE Pakistan.
Payout ratio is used as a proxy of dividend policy, which
was calculated by dividend per share with EPS. Debt to
equity ratio is used as a proxy of leverage. Moreover, tax
shield was calculated by multiplying the tax rate with
interest amount. Return on asset is used as a proxy of
profitability. Size was calculated by taking the log of total
5. Results and Discussion
Table 1 shows the mean, standard deviation, skewness etc.
For measuring the deviation of the variables from each
other’s as its objective is to investigate the relationship
between tax shield and dividend policy. Table 2 shows
that p-value of F-statistic are less than 0.05. Moreover,
F-statistic value is non-zero. Both these values prove the
model fitness. R square value shows that 7.23% variation
in dependent variable is explained by independent vari-
ables. In addition to this, results shows that there is in-
significant value between leverage and dividend policy as
its p-value is greater than 0.05.
Results also showed that there is significant positive
relationship between profitability and dividend policy. Its
beta co-efficient value is 0.000908 and there is insignifi-
cant relation between the leverage and the dividend policy
as its co-efficient is 0.000450 and also insignificant
relationship between tax shield and dividend policy as its
co-efficient is 0.005327 and insignificant relationship
between the size of the firm and dividend policy as its
co-efficient is 0.007738.
Table 1. Descriptive statistics.
Mean 0.027734 1.014639 10.14954 14.38144 8.879438
Median 0.015676 1.075000 10.07500 15.00000 8.797155
Maximum 0.593824 9.710000 53.51000 17.00000 12.75032
Minimum 0.714286 14.75000 46.73000 11.00000 2.734368
Std. Dev. 0.084186 2.447218 16.72553 1.529965 1.981065
Skewness 0.992175 2.178721 0.260952 0.196899 0.270824
Kurtosis 46.19498 15.63794 3.648231 2.224797 2.680634
Jarque-Beta 15113.76 1444.531 5.598424 6.111124 3.195959
Probability 0.000000 0.000000 0.060858 0.047096 0.202305
Sum 5.380321 196.8400 1969.010 2790.000 1722.611
Sum Sq. Dev. 1.367854 1155.853 53990.45 451.7732 757.4514
Observations 194 194 194 194 194
Tax Shield and Its Impact on Corporate Dividend Policy: Evidence from Pakistani Stock Market 187
Table 2. Regression analysis.
Dependent variable: PAY
Method: panel least squares
Sample: 2005 2010
Periods included: 6
Cross-sections included: 33
Total panel (unbalanced) observations: 194
Variable Coefficient Std. error t-statistic Prob.
Intercept 0.045003 0.059240 0.759678 0.4484
LEV 0.000450 0.002435 0.184959 0.8535
TS 0.005327 0.004029 1.322216 0.1877
PROF 0.000908 0.000418 2.168689 0.0314
SIZE 0.007738 0.005387 1.436339 0.1526
R-squared 0.072338 Mean dependent var 0.027734
Adjusted R-squared 0.052705 S.D. dependent var 0.084186
S.E. of regression 0.081938 Akaike info criterion 2.140280
Sum squared resid 1.268906 Schwarz criterion 2.056057
Log likelihood 212.6071 Hannan-Quinn criter. 2.106175
F-statistic 3.684498 Durbin-Watson stat 1.712100
Prob (F-statistic) 0.006493
6. Conclusion
The conclusion is that the firm size and profitability are
positively related to the dividend payout policy. Whereas,
our study showed the insignificant relationship between
the tax shield and leverage on the dividend payout policy.
Positive results mean that, if the company size and prof-
itability increase, the company will pay more dividends
whereas the tax shield and leverage will not affect the
dividend policy. Our study supports some studies and also
does not support some research findings. We support
Talat Afza and Hamad Hassan Mirza’s findings in 2010
and do not support the Kanwal Anil Study in 2008.
7. Limitations
This study is limited to the KSE and may not apply the
other countries and this sample shows these results other
study may find the different results more sample size may
shoe the difference result.
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