The effect of dividend imputation tax credits on market equilibrium

Abstract

Dividend imputation is a way to eliminate the double taxation of dividends. In Australia, imputation credits allow Australian companies to distribute taxes paid on corporate profits by the company back to shareholders with dividend payments. Resident shareholders can use these credits to reduce personal tax liabilities or to receive a tax rebate, while non-resident shareholders cannot use these credits. The value of imputation credits is different for different investors, which makes estimating the equilibrium market value of imputation credits difficult. My thesis provides a theoretical model to compare the market equilibrium before and after introducing imputation credits. It shows that the introduction of dividend imputation changes the nature of the equilibrium, including the risk-free rate, the market risk premium, the beta of each asset, and investors’ portfolio choices. Specifically, dividend imputation creates an incentive for investors to tilt their portfolios towards domestic assets that distribute imputation credits and away from foreign assets and domestic assets that do not distribute credits. This results in domestic investors receiving higher payoffs from their investment, but holding more concentrated portfolios and bearing more risk. I show that imputation causes a discontinuity in returns for some investors who are ineligible to redeem credits (because they are not resident investors) but who are required to pay back the entire face amount of any credit when taking a short position. This results in some investors holding no position in some assets. Such a corner solution means that the standard CAPM equilibrium does not hold. I first demonstrate these effects in a stylized model and then calibrate the model using data from the Australian and US equities markets. I also use the model to analyse a number of alternatives to dividend imputation, including reducing the company tax rate, reducing the tax rate on dividend income, and abolishing the redemption of excess imputation credits for low-taxed investors.