Tax Incentives and Capital Structures: The Case of the Dividend Reinvestment Plan

Abstract

This study investigates the impact of 1981 tax legislation (Internal Revenue Code (IRC) Section 305(e)) creating tax deferral for dividend reinvestment plans (DRPs) of qualifying utility companies. The intent of the legislation was to assist public utilities in raising new equity capital by encouraging reinvestment of dividends in qualifying firms. The effectiveness of this legislation is in doubt for at least two reasons. First, the tax benefits to any taxpayer were only $750 for single returns and $1,500 for joint returns. Second, clientele arguments (Miller [1977] and Miller and Scholes [1982]) suggest that taxpayers subject to low marginal rates would be typical investors in utility stocks. Both conditions imply that the economic incentives associated with dividend deferral might be small. Our results indicate that the second condition-low marginal rate taxpayers holding utility stocks-is not observed. Specifically, we observe a positive share price reaction at announcements related to