Miller and Scholes show that under certain conditions the Federal Income tax taxes dividend income at a rate no higher than the rate on capital gains. Tabulations of actual 1977 tax returns show that the special circumstances under which this can occur apply to less than 3% of dividend income and no significant role can be ascribed to their result in the determination of corporate dividend policy.

Daniel R. Feenberg

English

Research Papers in Economics

NBER WORKINGPAPER SERIES
DOES THEINVESTMENTINTEREST LIMITATION
EXPLAIN THE EXISTENCE OF DIVIDENDS?
Daniel Feenberg
Working Paper No. 530
NATIONALBUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
CambridgeMA02138
August 1980
Iwould like to thank Dan Frisch and Daniel Erdman who constructed
the original TAXSIMmodelused to tabulate these results and David
Bradford for comments. Support was provided by NSF Grant number
DAR.-7820093. The research reported here is part of the NBER's
research program in Taxation. Any opinions expressed are those of
the author and not those of the National Bureau of Economic
Re search.NBER Working Paper #530
August, 1980
Does the Investment Interest Limitation Explain
the Existence of Dividends?
AB S TRACT
Miller and Scholes show that under certain conditions the Federal
Income tax taxes dividend income at a rate no higher than the rate on
capital gains. Tabulations of actual 1977 tax returns show that the
special circumstances under which this can occur apply to less than
3% of dividend income and no significant role can be ascribed to their
result in the determination of corporate dividend policy.
Daniel Feenberg
National Bureau of Economic Research
1050 Massachusetts Avenue
Cambridge, Massachusetts 02138
(617) 868—3934Does the Investment Interest Limitation
Explain the Existence of Dividends?
Daniel Feenberg
"[the deduction of interesti permits the taxpayer to make loans for the
purchase of wholly exempt securities and then deduct the interest paid on
such loans from his otherwise taxable income, thereby reducing the tax."
——ASenate report of 19181
Miller and Scholes (1918) propose the following strong dividend invariance
proposition: "Given the firm's investment decision, the firm's dividend
decision will have no effect on the wealth or economic welfare of its
[rationall shareholders." This stands in sharp contrast to the conventional
view that taxable shareholders will prefer capital gains to dividends both
because capital gains are taxed at a lower rate and because taxation of such
gains is deferred until realization. This note begins with a short restatement
of the conditions necessary for dividend invariance to hold, and concludes with
ameasurement made from a large sample of the U.S. tax returns of the extent to
which these conditionshold. It is shown that the special circumstances under
which Miller and Scholes' hypothesis can occur are so rare that no role may logi-
cally be ascribed to the hypothesis in the determination of corporate dividend
policy.
Conventional finanical wisdom suggests that individual shareholders
could have saved half or more of the over eight billion dollars in taxes paid
on twenty—six billion dollars in dividend income reported on their 1911 indivi-
dual income tax returns. This would require only that firms make more extensive
use of well knowntechniquesfor converting dividends to capital gains.
Miller and Scholes present a clever explanation for this seemingly irra—
tional behavior of firms. They suggest that earlier authors have not read the—2—
tax code carefully, and that the rational, wealth—maximizing taxpayer—
shareholder will actually pay a lower rate of tax on dividends than on capital
gains. This surprising outcome is the result of the interaction of a time
honored tax dodge ——borrowingto finance tax favored investment ——and a little
known section of the current tax law which regulates that practice. In essence,
Miller and Scholes propose that for each dollar of dividend income that share-
holders receive they should borrow a sufficient sum of money to produce a one
dollar interest expense deduction. If the loan proceeds are invested in a
single payment annuity or some other tax favored security a net reduction in
taxable income is achieved.2 Furthermore, if the altered cash flow presents a
problem for the taxpayer, it may be possible to borrow against the increasing
cash value of the annuity to finance the interest payments due on the loan. By
this strategy, which Miller and Scholes dub "dividend laundering" it is possible
to builda portfolio with the risk—return structure of the stock, but with the
tax deferral advantage of the annuity.3 In an optimal portfolio enough income
wouldbe sheltered in this fashion to bring the taxpayer's current bracket rate
on ordinary income down to the effective bracket rate on capital gains. Because
this strategy minimizes taxes without changing the risk—return structure of the
portfolio, it dominates any portfolio with a lesser amount of debt.
Absent any other consideration this arbitrage opportunity would not
explain the existence of dividends, because capital gains could be sheltered
through the same mechanism. Indeed, because of the sixty percent capital
gains exclusion, the distribution of profits as capital gains would economize
on the possibly costly tax shelter. The hypothesized preference for divi-
dends is a consequence of Section 163(d) of the Internal Revenue Code, the
investment interest limitation.—3—
That regulation effectively limits the deduction of interest paid to mortgage
payments plus dividend and interest income plus 10,000 dollars.5
The intent of this rule was to allow deductions for interest paid on
mortgages and loans used to purchase assets producing taxable income and to
disallow the deduction if the proceeds of the loan are invested in a tax
favored device. Actually, any amount of interest or dividend income may be
sheltered with this device but the regulation does restrict the ability of
taxpayers to shelter labor income from taxation and it introduces an addi-
tional distinction between the taxation of dividends and that of capital
gains. For the taxpayer constrained by this section marginal capital gains
aretaxed at the regular capital gains rate but each additional dollar of
dividend income would allow the taxpayer to increase his borrowing suf-
ficiently to wipe out the additional tax liability. Such taxpayers maybe
expectedto prefer firmsto pay out profits as dividends rather than convert
thoseprofits to capital gains. Simply put, increased dividends allow the
taxpayerwho is constrained by the limit on interest deductions to increase his
borrowing for investment in tax shelter annuities. If this situation were
widespread, and the reasoning in Miller and Scholes' paper suggests it might
be, section 163(d) would provide an explanation for the observed dividend
policy of pubic corporations.
Section 163(d) is a recent addition to the tax law. An early version in
effect from 1969 to 1915 set a maximum investment interest deduction of 150%
of the sum of $25,000 and investment income, but investment income was
defined to include realized capital gains as well as interest, dividends,
rents and royalties. Only in the Tax Reform Act of 1975 were capital gains_)4..
excludedfrom investment income, so that only for tax years 1916 and beyond
does section 163(d) have any possible relevance to the dividend payout
sion. While there has been some increase in dividend payouts since 1975
there remains a very large base ——23 billion dollars ——wantingexplanation.
Miller and Scholes' article contains almost no data to support their
conclusions about the importance of section 163(d). The figures offered by
them on aggregate tax sheltered investment and aggregate interest deductions
are consistent with all or no taxpayers preferring dividends to capital
gains, depending on the correlation between investment in tax shelters and
debt.
A measure of the fraction of dividends received by taxpayers constrained or
nearly constrained by section 163(d) would be the most powerful empirical test
of dividend laundering as an explanation for observed dividend payouts.
Fortunately quite conclusive evidence on who receives dividends is available in
the 1977 Tax Model file prepared by the U.S. Treasury. The Tax Model is a
public use sample of 155,000 actual federal income tax returns selected from the
universe of 86 million returns. Because the sample is weighted heavily towards
high income taxpayers (and includes the return of every taxpayer with any income
item over 200,000 dollars) sampling errors are roughly independent of income
level. For reasons of econonr in this tabulation a subset of the treasury file
is used including one half of the returns with adjusted gross income over 200,000
dollars and one tenth of all other returns.—5—
InTable one column five shows the number of taxpayers constrained or
nearly constrained by section 163(d). A taxpayer is regarded as being nearly
constrained if a reduction in dividends of one thousand dollars would subject
him to the limitation on the deduction of investment interest. The estimate
number of such taxpayers is small; however in the highest income categories
almost 1/3 of taxpayers are constrained. Columns six and seven show the total
dividends received by all taxpayers and by constrained (or nearly constrained)
taxpayers, respectively. Miller and Scholes do suggest that the number of
constrained shareholders may not be very relevant to the dividend payout deci-
sion ——they may be few in number but important in corporate decision making. In
no income class do constrained taxpayers receive as much as fifteen percent of
dividend income for that class, and overall they receive only about two and one
half of percent of such income. It is not credible that so small a segment
of the ownership of a public corporation could determine dividend policy to the
detriment of the other taxable owners of the stock. Nor does the conclusion
change significantly if the point estimate of dividends received by constrained
taxpayers is off by several standard errors.
Because the constraint implicit in section 163(d) is not binding for any
significant fraction of taxpayers, or for taxpayers receiving any significant
fraction of dividend income, it is impossible to ascribe to that section any
significant role in the determination of corporate dividend policy.T
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 —1--
TABLE1Continued
1.Income is adjusted gross income plus the excess of interest deductions over
"investment income."
2. Includes all single and joint returns but not married filing separately.
3. Interest income +rent+royalties+dividends—(interestdeductions —
mortgageinterest) greater than zero.
4. As in column 3 but with sign of inequality reversed.
5. Number of taxpayers whose interest deductions placed them at or within 1,000
dollars of the point where section 163(d) is binding. For those taxpayers not
filing form 4952 the 'other interest' line of schedule B is used as an upper
limit on the amount of investment interest.—8—
Footnotes
1-Senate Report No. 617, 65th Congress, 3rd Session 7(1918),quoted in Klein
(1962).
2There is an alternative simpler strategy not mentioned by Miller and Scholes.
Thetaxpayer could sell his stock and purchase an insurance policy with the same
risk and return as the stock. We know that the insurance company could offer
such a policy; itneedonly add the relevant stock to its portfolio to beper-
fectly hedged.The more complicated procedure does manage to avoid a capital
gains realization. The point to remember is that the borrowing and lending
doesn't create any new tax shelters, it simply alters the rewards of those which
already exist.
3or fairly detailed, but hardly conclusive views of the legality of this proce-
dure, the reader is referred to Klein (1962) and Asiniov (1977). In principle
the interest deduction may be disallowed if the combination of loan and tax
shelter has no significant beneficial function other than the reduction of
taxes. In practice the IRS is likely to disallow the deduction if the only
security for the loan is the cash value of the shelter. For the taxpayer with a
small enough spread between his borrowing and lending rate this need not be a
serious obstacle, since some other collateral may be used.
Details of Section 163(d) are in Bierman and Stechel (1977).
5Briefly, the investment interest deduction is the interest deduction less the
home mortgage deduction.—9--
FootnotesContinued
61f the realization of the capital gain can be deferred indefinitely then it is
effectively tax—free and taxpayers should display complete indifference between
dividends and unrealized capital gains.—10—
References
Asimov, Michael, "The Interest Deduction," UCLA Law Review, Vol 2, p. l49,1911.
Bierman, Jacquin D. and Ira Stechel, "New Investment—interest Rules Restrict
Deduction and Pose Definition Problernz," Journal of Taxation, April 1977, pp.
21L2—2)46.
Klein, William A., "Borrowing to Finance Tax—Favored Investments," Wisconsin Law
Review, Vol. 1962, p. 608,July1962.
Miller, Merton H. and Myron S. Scholes, "Dividends and Taxes," Journal of
Financial Economics 6(1918),pp. 333_36I, December 1968.

Does the Investment Interest Limitation Explain the Existence of Dividends?

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