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When dividends are paid, the share price is depressed in proportion to the size of the dividend, so the shareholder breaks even. If the dividend is paid in cash, the shareholder can buy shares with it, and if it's paid in shares the shareholder can sell them for cash. Or the shareholder can obtain a dividend even if the company doesn't give it out by, say, selling a few percent of his/her holding each year. It all boils down to the same thing.

It might be worth revisiting Keynes. The key word is liquidity...

Investments which are 'fixed' for the community are thus made 'liquid' for the individual.
...
Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called 'liquidity'. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of an investment institutions to concentrate their resources upon the holding of 'liquid' securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance whichh envelop the future. The actual, private object of the most skilled investment of to-day is 'to beat the gun'. as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.
...
These tendencies are a scarcely avoidable outcome of our having successfully organised 'liquid' investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmonton Street is, compared with Wall Street to the average American, inaccessible and very expensive. The jobber's 'turn', the high brokerage charges and the heavy transfer tax payable to the Exchaquer, which attend dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market (although the practice of fortnightly accounts operates the other way) to rule out a large proportion of the transactions characteristic of Wall Street.[4] The introduction of a substantial overnment transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.
The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets ovten facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is 'liquid' (though this cannot be true of all investors collectively) callms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are availale to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and know very little about them), except by organising markets wherein these assets can be easily realised for money.

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Fri Dec 22nd, 2006 at 06:45:15 AM EST
[ Parent ]

An excellent post! (none / 0)

"to pass the bad, or depreciating, half-crown to the other fellow"
+
"make the purchase of an investment permanent" ie less liquid
=
dilemma

For which I'd like to know the answer...

Ignoring the practicalities of changing well-established markets, what instrument could society use to promote corporate enterprise and reduce individual or grouped speculation?

You can't be me, I'm taken

by Sven Triloqvist on Fri Dec 22nd, 2006 at 08:05:14 AM EST
[ Parent ]

Re: An excellent post! (4.00 / 2)

Well, they could do what the entire Canadian market has done ie Companies can bung that part of their gross revenues which is in excess of "costs" into a legal wrapper and sell them off to investors in the form of "units".

So that investors get their hands on revenues BEFORE the management does. It makes the investment far less speculative.

Bugger trust law of course - a wrapper based upon French jurisprudence is better (Three Guesses what that could be), except the French haven't woken up to it, eh Jerome?

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Fri Dec 22nd, 2006 at 09:31:14 AM EST
[ Parent ]

When dividends are paid, the share price is depressed in proportion to the size of the dividend, so the shareholder breaks even. If the dividend is paid in cash, the shareholder can buy shares with it, and if it's paid in shares the shareholder can sell them for cash. Or the shareholder can obtain a dividend even if the company doesn't give it out by, say, selling a few percent of his/her holding each year. It all boils down to the same thing.

I agree with your comment, but would present one small correction. For the investor who doesn't want to withdraw cash from his investment in a company--say he really believes in the company and wants to leave all his money in for 10 years--he is forced to take a dividend. And while you are correct that he can buy stock with the dividend, he is first taxed on the dividend payment. The dividend tax rate is historically low for the US today, 15%, but if it's a $1000 dividend, he would only have $850 after tax to reinvest. This investor would be theoretically better off if the money was left in the company.

by wchurchill on Fri Dec 22nd, 2006 at 05:19:59 PM EST
[ Parent ]

If the dividend tax rate is higher than the tax on sold shares, then it is beneficial for the investor to sell the shares themself if he wants a "dividend", and conversely. Now, the question is, if a dividend is paid in shares, doesn't the investor pay tax on that? That would make a dividend paid in shares optimal for the investor. It makes no difference to the company.

I seem to recall that un Spain there would be no tax on stock sales if the shares had been held for a period of several years. That gave the long-term investor an advantage consistent with their greater social utility. I don't know what the situation is currently.

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Fri Dec 22nd, 2006 at 05:35:55 PM EST
[ Parent ]

That would be another solution - to apply tax based on timed holdings. I.E - the less tax is paid the longer you own the shares. And not too difficult to implement. A kind of tax on liquidity.

After 5 years, for instance, no tax would be payable.

This was the company taxation law in Finland for start-ups, until recently. If you started a company and owned shares (which then required a minimum 100% capital of around 8000 €) you would pay capital gains tax if you sold within 5 years - I forget how much - but after 5 years it was all tax free.

This lead to an increase in entrepreneurship that still echoes today in Finland. 5 years happened, at the time, to be the period it would normally take to build up a viable operation with a proof-of-concept that then required further capital for exploitation. The extra capital needed meant sell-out of part or all.

But this adheres to the Peter Principle which states, crudely, that there are some people who start companies. some who grow them, and yet others who run them on the upper plateau. And very rarely can one find these talents in a single management culture.

The Finnish tax described above was seed money. It said "You risk 8000, but you could win millions". And the subtext was "You are not the right people to build it anyway"

To me, this is what governments should do: firstly, there is an ongoing actuarial analysis of present trends, extrapolated to future trends. Then instruments have to be found that dick with those trends, if they are considered to be ultimately detrimental to the 'social good'.

The 'social good' is the only thing that governments should concern themselves with. That is why they 'represent' us.

All law is to do with habituation. The sum total of what all the members in a society accept as 'normal' is behavioural. It is not good for everybody, but it is good for the majority of members. 'Strange Fruit' on the trees of the US South 50 year ago have produced a behavioural change that would never have happened without media. Strange behaviours in a society have to be explained and then accepted or rejected - that is the role of the media: the 4th Estate.

We behave very differently as individuals, but we are rather predictable in our general attitudes because we rarely have a good choice (perfect match) in our representation. Our individual lives are analogue, but our choices are discrete - rough with the smooth.

So what I am arguing for <ducks> is a reassessment of democracy. Does 'one person, one vote' still cut it when most of the voters are traumatiised into behavioural acquiesence by the MMS?

You can't be me, I'm taken

by Sven Triloqvist on Fri Dec 22nd, 2006 at 08:24:04 PM EST
[ Parent ]

interesting point. If you have held the shares more than 12 months the gains would be long term, taxed at 15%, which is the same as the long term gain tax. However, if you held them less than 12 months, the tax is your ordinary income tax, which is as high as 35%--talking Federal tax only.
Dividends paid in shares are taxed just like cash, so there's no real advantage to a share dividend, and therefore you don't see many of them.

by wchurchill on Fri Dec 22nd, 2006 at 09:19:44 PM EST
[ Parent ]

we may be getting lost in the back and forth here,,,but I think you are pointing out, that if dividends are not paid by the company, the investor can decide upon his own when to take the "dividend", ie:cash out of his investment, but simply selling shares. and in the US, this receives the lower tax rate of capital gains, on the gain. and I think that is a correct theoretical view.

Not to complicate this, but just fyi, there is a view among some investors that if managment has to pay a "cash" dividend, they are more accountable. both in the sense of every quarter paying cash of some amount, and second, there is some gamesmanship that can be played in the world of accounting with income (versus cash--potential chicanery)--but those games tend to go away when it comes to writing someone a check. these comments get into a somewhat arcane world of accounting, and apologies, though I think you understand them, as they are pretty esoteric.

by wchurchill on Sat Dec 23rd, 2006 at 02:46:49 AM EST
[ Parent ]

This explains why dividends seem to be falling out of favour. With electronic trading and online brokerage, even by retail banks, it is so easy to withdraw cash from your investment that a dividend is generally bad for the investor.

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Sat Dec 23rd, 2006 at 06:13:28 AM EST
[ Parent ]

A common misconception. A shareholder gains zero when a firm releases a dividend.

If you read french, I wrote Les dividendes enrichissent-ils les actionnaires ?.

BTW, does anyone know the tax treatment of share buybacks?

by Laurent GUERBY on Fri Dec 22nd, 2006 at 10:47:40 AM EST
[ Parent ]

Explain why a shareholder gains zero.

You can't be me, I'm taken

by Sven Triloqvist on Fri Dec 22nd, 2006 at 10:52:13 AM EST
[ Parent ]

That's what my french blog entry does :)

In short:

Because everyone can buy a share just at the end of the day before the dividend "ex-date" and sell it at the beginning of the next trading day while having gained the right to receive the full dividend.

So if the share closes at $100 and gives you a $5 dividend, if the share open at $100 every bozo on earth could earn $5 by buying then selling without taking any risk. So in practice, the share opens at $95.

For the shareholder: before $100 in one share, after $95 in one share and $5 in cash. Zero gain.

If you don't believe me, look at my french blog example: when microsoft paid a total $30 billion in dividends on the week-end after friday 12 november 2004. Shareholders gained next to nothing.

by Laurent GUERBY on Fri Dec 22nd, 2006 at 11:10:12 AM EST
[ Parent ]

You've given me a 4 without understanding my comment. LOL

When dividends are paid, the share price is depressed in proportion to the size of the dividend, so the shareholder breaks even. If the dividend is paid in cash, the shareholder can buy shares with it, and if it's paid in shares the shareholder can sell them for cash. Or the shareholder can obtain a dividend even if the company doesn't give it out by, say, selling a few percent of his/her holding each year. It all boils down to the same thing.

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Fri Dec 22nd, 2006 at 11:32:34 AM EST
[ Parent ]

Not at all. I 4 you just for breathing...

I'm trying to find out how the process of periodic reward for investment has been subverted by speculation/liquidity (the dilemma).

And whether there are remedies. I'm thinking of the LLP model again.

You can't be me, I'm taken

by Sven Triloqvist on Fri Dec 22nd, 2006 at 12:10:54 PM EST
[ Parent ]

In the US it's a non-taxable event.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Fri Dec 22nd, 2006 at 11:54:29 AM EST
[ Parent ]

That makes a difference, because you do pay taxes when you buy or sell stock.

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Fri Dec 22nd, 2006 at 11:58:04 AM EST
[ Parent ]

BTW, does anyone know the tax treatment of share buybacks?

In the US, there is no tax impact for the buyer of the shares at the time of the purchase--tax impact comes when those shares are sold at a later date. So for the company that buys back shares, it is not a taxable event.

For the person who sells those shares, he of course has a taxable event, and will recognize long or short term capital gain, or capital loss,,,,,,depending on how long he has held the shares, and how the shares have performed in that period.

by wchurchill on Fri Dec 22nd, 2006 at 05:26:37 PM EST
[ Parent ]

Tax and share buyback (none / 0)

Let's say a company with a market cap around 100 millions USD manages to make this year around 6 millions USD in "profit". Let's say at the end of the year there are one million shares, each one valued at 106 USD.

Option A: company declares the 6 millions profit, pays about 2 millions in taxes (assuming rate = 33%) and pays 4 millions to shareholders in dividends. (In most countries, this 4 million will also be taxed as income to shareholders.)

Option B: company buys 6 millions USD / 100 (average price) ~= 60 000 of its own shares and cancels them. Assuming the company will be able to turn in the same 6 millions USD profit next year and assuming a constant earning per share, the new 940 000 shares should be valued at 106.38 USD.

If I understand correctly what you and ATinNM are telling me zero taxes are paid by company in option B.

The shareholder in option A will pay near or no capital gain if he sells his share (initially bought at the beginning of the year) after the dividend, and in option B he will pay capital gain tax.

From the state point of view, seems to be close, a more accurate model (real taxation rates, interest rates, company valuation model taking into account profit taxes) would be needed.

Any reference?

by Laurent GUERBY on Sat Dec 23rd, 2006 at 05:27:00 AM EST
[ Parent ]

In option B...

does the company sell the shares at $100 or at $106? Wouldn't it be selling 56600 shares at $106 rather than 60000 shares at $100? That would leave 943400 shares valued at $106. In your calculation the share buyback results in a +$0.38 bump to the share price, which seems inconsistent.
aren't the assumptions about performance in the next year supposed to be factored in the share price already? [constant earnings per share is indeed a necessary assumption]

In any case, it seems share buybacks are "better" than dividends because the shareholders do not have to implicitly pay any tax on the company's profit: they get $6M as opposed to $4M.

If corporations pay tax only on profit, does this mean that they can use share buybacks to pay no tax at all?

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Sat Dec 23rd, 2006 at 06:06:14 AM EST
[ Parent ]

My model is not good enough for this level of accuracy (as I said) and is indeed not consistent.

Since you can't buy groceries with your shares, the shareholder wil have to sell, when he sells he will pay capital gain tax (or income tax), which can be more than company profit taxes.

If you bought at 100 and sold at 106, you make 6 in additional income which is taxed. If you hold on your share longer, you need to take into account risk-free interest rate, etc...

I don't know if retirement funds are taxed on capital gain, if not, we now know why they vote for share buybacks.

by Laurent GUERBY on Sat Dec 23rd, 2006 at 06:36:45 AM EST
[ Parent ]

Retirement funds can be legally organized, in the US, in so many ways a general answer is impossible.

But, if your ready for this one, the US goverment, in its wisdom, allows corporations to put their own stock in their internal retirement plan. So when they buy back shares they also increase the estimated net worth of that fund as well.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sat Dec 23rd, 2006 at 12:36:09 PM EST
[ Parent ]

The risk-free interest rate doesn't exist...

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Sat Dec 23rd, 2006 at 05:14:52 PM EST
[ Parent ]

Well, let's call it the best approximation of it and forget about the approximation :).

by Laurent GUERBY on Sat Dec 23rd, 2006 at 06:12:57 PM EST
[ Parent ]

I have a serious point to make with that, and that is that the assumption that there is a single lowest interest rate at which it is possible to both lend and borrow is simply not true. Well, it might be true for banks (i.e., market makers), for instance in London they can all borrow from each other at LIBOR, but other market participants don't have access to that, and can borrow and lend at different rates.

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Sat Dec 23rd, 2006 at 06:17:41 PM EST
[ Parent ]

The risk free rate is when someone lends to the state, and in France at least you can buy various "BTAN", "OAT" that gives you this rate (with a tiny spread, France being one of the best borrower of the eurozone and also near zero bank margins), the government recently announced measures to ease the access to state debt for consumers.

By definition lending to any other entity will get a higher rate.

And of course banks take their margin for most products, I believe I would get interest of EURIBOR 3 or 6 monthes minus 15 basis point if I block money for the duration at my bank.

by Laurent GUERBY on Sun Dec 24th, 2006 at 04:48:31 AM EST
[ Parent ]

And only the state gets the risk-free rate when they borrow, banks get interbank rates (LIBOR, EURIBOR...) and people get the shaft.

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Sun Dec 24th, 2006 at 04:52:13 AM EST
[ Parent ]

Missing an Important Point (none / 0)

In the US - Your Tax Laws May Vary - OK?

In option B neither the Corporation nor the investor has to pay taxes on the $.38 increase in share value. Focusing on the latter, no money has been "constructively received" by the shareholder thus there is no tax event.

In your example, the $.38 can be viewed, by the investor, as the monetarized value of a tax-free compounding rate which increases the Internal Rate of Return of the investment. (Does that make any sense?)

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sat Dec 23rd, 2006 at 12:26:56 PM EST
[ Parent ]

Re: Missing an Important Point (none / 1)

$0.38 means nothing here, it is far below the errors and approximations I made.

by Laurent GUERBY on Sat Dec 23rd, 2006 at 06:14:04 PM EST
[ Parent ]

Re: Tax and share buyback (none / 1)

No and I apologize if my previous answer was confusing. In both option A and B the company will pay the taxes. So the company pays $2 million in both cases.

the difference comes with the shareholders. When the shareholder receives the dividend at the end of the year, he/she pays taxes at the dividend rate, now 15% in the US. The difference really comes for those shareholders who are long term investors, and don't want the annual dividend payments. If no dividend is paid, and the money is left in the company, and the company continues profit growth as you suggest, the individuals money grows without any of it being taxed. Then say at the end of 10 years he sells, he then pays a 15% capital gains tax--but all of "his earnings" in the company have grown without him paying the 15% tax on the annual dividend. So the 10 year holder not paying dividends, gets the full compounding effect on his portion of the earnings.

If he invested in an identical company that paid the dividend every year, he would pay the personal tax on the dividend each year, and thus lose the opportunity to compound his gains on the portion paid in taxes.

This is less of an issue in the US than it was in the past. So for example, 6 years ago the top federal income tax for individuals for ordinary income was about 40%, and that rate also applied to dividends. So this meant earnings were taxed at (using your example) 33% by the corporation,,,and then the dividend was paid after the corporate tax was taken out,,,,,and the dividend was taxed again at the 40% level. So just to play that out, if my portion of the corporate earnings was $10,000, the company was going to pay $3,333 in taxes to the government. Then if the company was paying all after tax earnings out as dividends, I would get the remaining $6,667 paid to me as a dividend, and I would pay another $2,667 to the Federal Government. So of my $10,000 portion of the earnings, I would be taxed twice and pay $6000 in total to the government, and receive only $4000--a combined tax rate of 60%. And in New York or California, state tax would take at least another $667.

This "double taxation" effect on dividends caused companies to reduce their dividend payouts as a % of after tax earnings from something like 3.5% in the '70's to 1.2% in the early 2000 (from memory, but it was dramatic). The view of companies was that it was better for the shareholder if the money was left in the company, not double taxed as a dividend, and then the shareholder could sell shares when he needed money, and the capital gains tax rate was lower than the ordinary income tax rate, so the shareholder did better. Now at lower and equal dividend and capital gains tax rates of 15%, this is less of an issue, and companies are gradually starting to pay more in dividends.

by wchurchill on Sun Dec 24th, 2006 at 01:57:43 AM EST
[ Parent ]

Re: Tax and share buyback (none / 1)

Thanks for those precisions.

Here is what I know about taxation in France for 2006 income and profits:

Company profit taxation is at 33.33%.

Marginal effective income tax rate is at 40% (kicks in after 66 679 euros of income).

When you receive a dividend, up to 1 525 euros per person, you can remove 40% of the amount, the rest is counted as income.

Some fixed interest products (including state debt) has a marginal rate of 27% (if you choose "prélèvement libératoire" as most "rich" people do, otherwise it is taxed as income - interesting for low revenue).

French "Plan d'Epagne en Action" (financial vehicle where you can put pretty much whatever you want: shares, indices, ...) capital gain is taxed at 11% after 5 years, but there is a investment cap at 132 000 euros per person (current value can be above).

The big french saving product is "assurance vie", after 8 years capital gains are taxed at 7.5% for the part above 4600 euros per person per year (if I understand correctly, I have no such product).

Unsurprisingly "assurance vie" is the most popular financial product in France, and I guess managers of such funds encourage share buybacks.

by Laurent GUERBY on Sun Dec 24th, 2006 at 05:46:54 AM EST
[ Parent ]

thanks, this was very interesting. I'll take some time later and go back and work with the articles in French--dificile pour moi, mais une bonne methode a apprendre (forgive my French).

it does look like for truely long term investing, l'assurance vie would be good, particularly if the investment was in well diversified funds, such as index funds. Investing in individual companies would be problematic, because their fortunes may turn downward and you have to sell early. but investors that have invested over truely long periods of time in the S&P 500, for example, have done pretty well,,,,so 10,000 EU may double every 7 years, and at the end of 21 years be worth 80,000--taxed at only 7.5% would leave one with 74,750. or better yet, invest 10,000 this way at 30 years old, and cash in at 65--theoretically it doubles 5 times to 320,000, minus the 7.5%. that is "theoretically" of course.

I didn't realize the top french ordinary income tax rate was 40%, if I understand you right. the US is 35%, but not much difference. I think the french rate takes effect at a lower income, however.

thanks again, i enjoyed the comments and links.

by wchurchill on Sun Dec 24th, 2006 at 11:26:40 AM EST
[ Parent ]

One problem with the french tax code is that it's full of holes, there are more than 600 tax holes. There are some top income people who pay zero income tax.

The legislator passed a law to cap the amount of exemption at some number, but constitutional court rejected the article as "too complex" (it was the same as a cap of taxes on income at 60% which was not censored by the same court - a real scandal).

So take the frenhc marginal tax rate with a grain of salt.

by Laurent GUERBY on Sun Dec 24th, 2006 at 12:34:46 PM EST
[ Parent ]