African Journal of Business Management Vol. 6(8), pp. 2951-2954, 29 February, 2012 Available online at http://www.academicjournals.org/AJBM DOI: 10.5897/AJBM11.

1767 ISSN 1993-8233 2012 Academic Journals

Full Length Research Paper

The effect of taxes on dividend policy of banking sector in Pakistan

Zeeshan Hamid , Ch Asad Hanif , Shahzada Saif -Ul-Malook and Wasimullah *
1,2 1 1 1

Management Sciences department, Air University, Islamabad, Pakistan. 1 Learning Resource Centre, National Bank of Pakistan, Islamabad, Pakistan.
Accepted 24 November, 2011

The purpose of this study is to explore the impact of taxes on dividend policy of banking sector in Pakistan. The data obtained from the financial reports of 21 banking companies listed on Karachi Stock Exchange over a period of five years (2006 to 2010) is used in this study. Pearson correlation and regression is used to find the relationship of tax and dividend income. The results show a significant correlation between taxation and dividend income of the banks and also suggest that the tax-rate is an important determinant of dividend policies of the banking sector. Key words: Dividend policy, taxation, dividend income, tax-rate. INTRODUCTION

Dividend policy is the exchange between retained corporate taxes with other legal taxes to the government. earning and paying out cash or issuing new shares to The taxes no doubt decrease the profits of the business; shareholders. Some organizations pay out low dividend as such, they retain and distribute it as a dividend to because management is expecting some positive results shareholders of the company. about companys future and need to retain their earning The objective of this study is to evaluate the eff ect of in f uture aspects. It is difficult to deny that taxes are taxes on dividend policy in the banking sector of important to investors. While, dividend affects the liability Pakistan. This study will also evaluate the role of taxes to of shareholders tax, in general, it does not change the determine the dividend policies of the banking sectors. taxes that must be paid in or the company distributes and This study might be helpf ul to policy makers to better retains its profit. understand how taxes impact dividend policies and they Brennan (1970) and Masulis and Trueman (1988) have will be in a better position to develop dividend policies by described in their theory that taxes inf luence dividend keeping in view the affect of taxes. policy of organizations. If this theory were true, the changes in dividend payout of the company would be anticipated every time the government changes its LITERATURE REVIEW income tax policy. This characteristic may have continued in Modigliani and Millers (1961) theory, which provided a Leroy and Barbara (2008) suggested in their study that guideline for discussion and research on dividend policy. bef ore- and after-tax returns to capital cannot be preDividends are typically paid to owners or shareholders of cisely separated from the tax system. They emphasized company at specific periods. This appears based on the that in the best dividend payout behavior, one cannot be declared earning of the company and the suggestion separated away from equilibrium concern and the made by its management. If the company made no profit, analysis of the effect of taxation on business valuation. then dividends cannot be declared, but when company Masulis and Trueman (1988) proposed that due to the makes profit, it is the responsibility of management to pay delay in personal tax advantage of dividend, the shareholder greatly prefers to invest in real assets to use internal financing as compared to external. The profitability of internally financed security investment is dependent on the tax status of security and also the tax bracket of *Corresponding
author. E-mail: Zeeshan.hamid83@gmail.com.

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shareholder. In contrast, externally-financed security important aspect that establishes the shareholders purchases are making loss from a tax stand point. wealth. Nnadi and Apkomi (2008) evaluated the tax effect on Baker at al. (2001) suggested that managers use the dividend policy of Nigerian banks and proposed in their Linters (1956) model in decision making regarding study that various f actors influenced the dividend pattern dividend policy. The pattern of past dividends, strength of of companies. Due to the accessibility of the profit, the earnings, and the level of existing and projected future dividend policy of the banks is to frequently sustain a low earnings are the most significant factors for the managers but constant payout. The most important factor of the when they made the dividend decisions. dividend structure is the liquidity position of the company. Baker at al. (1985) described the different types of Dividend clients are a very alarming aspect in the conclusions in their survey. The results of first survey concern of a dividend policy. show that the most important determinants of dividend Kose and Williams (1985) identified the signaling payments were similar to Linters model developed in equilibrium with taxable dividends in their theory. They 1956. In the second survey, results show that the described in their theory that the employees of the orgadividend policy has strong influence on share value; nization, with more essential and confidential information, moreover, the most important point is that the dividend best allocate larger dividends and obtain higher prices for policy is used to maintain or increase stock price. At last, their stock whenever firms have a demand of cash; thus, the respondents view is that the utilities obviously vary its existing stockholders exceed its internal supply of from those of the other two industries. cash. Travlos at al. (2001) examined the response of growing Aelee et al. (2011) explained that the comparison of stock market of Cyprus when the listed firms announced benchmark to a market and ownership levels between the increase in their cash dividend and also, the bonus firms, and institutional funds are important in stocks that issue in the form of stock dividends. The payout dividend pay dividends. Dividend patrons theories hypothesize policies of the growing stock markets in Cyprus are that institutions are attracted to dividends for two understood by the settings of microstructures, tax reasons. First, because dividends are tax advantaged for establishment and control situations of different markets. institutions and second, because of prudent-man rule Actually, the careful attempt made by the listed limitations. companies of Cyprus has significant impact on dividend Litzenberger and Ramaswamy (1982) examined in their increase and association of the information of irregularity study that there is a positive but non-linear relationship gap with investors through their dividend payout policy. between return on common stock and dividend yields. Wu at al. (2008) established a positive relationship The prophecy rule for the expected dividend yield is among cash dividends and administrative options. It based only on information that should be available to the means that management holding stock options may wish investor, and hence is free from possible information to allocate cash dividends to increase the stock price. effects that are controlled in dividend yield variables that Many earlier theories f ocused on the non-dividend predict the amount of a dividend. protected options, but this study considered the protected Feldstien and Green (1983) provided a simple model of options of dividend in Taiwan that vary with the earlier market equilibrium and explained the reason why studies. In following stock repurchase, the employees companies that capitalize on the value of their shares pay manipulate the motivation of stock options. Specifically, dividends. Still, the funds could be preserved and then the firms repurchase shares to f und options, sinking the issued to shareholders in a manner that they would be possibility of signaling for firm undervaluation. Collected used more favorably as capital gain. In fact, it is the samples of major Pakistani companies that are quoted on arrangement of the contradictory preference of the Karachi Stock Exchange for the period 2002 to 2008 shareholders in different tax collections and their need for and described the linkage between dividend policy and portfolio diversification in the features of uncertainty that corporate leverage of these firms. The analysis is collectively makes all companies to pay dividends. Tax performed by taking into consideration a model that links behaviors of dividend change the corporate financial the corporate dividend per share at a time t with the debt decisions and might be the reason of a misallocation of ratio of the firm, the dividend yield and the adjustment of entire investment. the earnings of the firm. Dividend yield and leverage have Azhagaiah and Priya (2008) analyzed in their study that major impact on dividend per share but the relationship of in general, five variables have impact on the shareleverage with dividend per share is negative; although holders wealth, that is, growth in sales, improvement of change in earnings can impact dividend policy under profit margin, capital investment decisions, capital certain condition. structure decisions, and cost of capital. Usually, the Theis and Dutta (2009) examined the Dickens model of higher dividend increases the market value of the share bank holding company dividend policy. They suggested and lower dividend decrease the market value of the that the original model is forceful, but all the variables share. Shareholders are privileged to have the current cannot maintain their significance. The shareholders of dividend to future income, so dividend is measured as an the firms have a non-linear relationship with dividend

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Table 1. Descriptive statistics.

Variable N Mean Std. deviation Dividend 21 403777.61 571056.28 Tax 21 1359586.67 2785681.92

Table 2. The corr elation between tax and dividend.

Variable Dividend Tax Pearson correlation 1 0.736** Dividend Sig. (2-tailed) 0.000 N 21 21 Tax Pearson correlation 0.736** 1 Sig. (2-tailed) 0.000 N 21 21

**Correlation is significant at the 0.01 level (2-tailed).

Table 3. Regression results.

Change statistics DurbinAdjusted R Std. Error of the estimate 1 0.736(a) 0.541 0.517 396768.134 0.541 22.430 1 19 0.000 1.745
2 2

Model R R

Watson 2 R change F change df1 df2 Sig. F change

Dependent variable: Dividend

yields. be an adequate representation of the study. Pearson correlation is Ahmed and Javid (2009) proposed in their study that used to find the relationship
of dividend policy.

of tax and dividend income, while regr ession is used to evaluate the role of taxes in the determination

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 Data analysis

Table 1 shows the mean and standard deviation of tax than previous dividends. The listed non-financial and dividend of banking sector. The mean of dividend companies having high momentum of modification and and tax are 403777.61 and 1359586.67 respectively, low target payout ratio, show instability in smoothing their while the standard deviations are 571056.28 and dividend payments. 2785681.92. Pearson correlation coefficient was used in correlating the variables when applied to find out the relationship Theoretical framework and hypothesis generation between taxes and dividend. Table 2 explains the correlation between the variables and show that tax and H : There is an association between taxes and dividend dividend have a significant correlation is 0.736. The figure policy. demonstrates that both tax and dividend are positively H : Tax rates impacts the dividend policy. correlated with each other. The value of R in Table 3 is 0.541, which shows that 2 model is good fit and in this case, tells that 54% of variation in dependent variable is explained by independent variable. The value of Durbin Watson is 1.745 which illustrate that there is no past error in the data. The study supports the hypothesis as the regression analysis shows

METHODOLOGY Secondary data acquired from the financial reports of the banks over a period of 5 years (2006 to 2010) was used. The sample size consists of 21 banks in Pakistan that are quoted on the Karachi Stock Exchange (KSE), Pakistan. The system atic sampling

that dividend policy is impacted by tax rate.

technique was used for this study. The selection of the system atic

The regression in Table 4 shows the

linearity

between

sampling

technique is arranged to find convenient sam ples that will

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Table 4. Model summary.

Model Predictors Unstandardized coefficients Standardized coefficients T Sig. B Std. Error Beta 1 (Constant) 198703.347 96805.972 2.053 0.054 Tax 0.151 0.032 0.736 4.736 0.000
Predictors: (constant), tax; dependent variable: dividend.

the dependent and independent variables. The t-figure

Brennan M (1970). Taxes, mark et valuation and corporate financial

4.736 shows that the tax rate has association with

policy. Natl. Tax J., 23: 417-427. Aelee J, Gallagher R, Partington H (2011). Institutional dividend

dividend policy. The

beta value gives the input of each of

clienteles under an Imputation Tax sys tem. J. Bus. Financ. Account.,

the independent variable. The beta figure is 0.736, which

38(1): 198-224.

points out that tax has strong correlation with dividend

Kose J, W illiams J (1985). Dividends, Dilution, amd Taxes: A signaling

policy. It also suggests that tax rate influences the

Equilibrium. J. Financ., 40(4): 1053-1070. Leroy F, Barbara S (2008). Dividend policy and income taxation; University of California.

dividend policy.

Litzenberger H, Ramas wamy K (1981). The effect of dividends on Common stock prices tax effect or information effect? J. Financ.,

Conclusion

37(2): 429-443. Masulis RW, Trueman B (1988). Corporate Inves tment and Dividend Decisions under Differential Pers onal Taxation. J. Financ. Q. Anal.,

The study suggests that there is positive correlation

23: 369-386.

between taxation and dividend income which supports

Modigliani F, Miller MH (1961). Dividend polic y, growth and the

the first hypothesis. The study also suggests that there is

valuation of s hares. J. Bus., 34(4): 441-433. Nnadi A, Akpomi M (2008). The effect of T axes on dividend policy of

strong relationship

between the dependent and

banks in Nigeria. Int. Res . J. Financ . Ec on., 19: 48-55.

independent variables, which confirm the study of Nnadi

Travlos N, Trigeorgis L, Vafeas N (2001). Shareholder wealth effects of

and Apkomi (2008). The tax rate is the important

Dividend polic y changes in an emerging stoc k market: The cas e of

determinants in the formation of dividend policies of the

Cyprus. Multinatl. Financ. J., 5: 87-112. Theis J, Dutta S (2009). Explanatory factors of bank dividend policy: revisited, Manag. Financ., 35(6): 501-508. Wu C, Kao C, Fung G (2008). Impact of dividend protected employee stock options on payout policies: Evidence from T aiwan. Pac. Econ. Rev., 13(4): 431-452. REFERENCES

banking industries.

Ahmed H, J aviad Y (2009). The determinants of dividend policy in Pakistan. Int. Res. J. Financ. Econ., 29: 110-125. Azhagaiah R, Priya N (2008). The Impact of dividend on shareholders wealth. Int. Res. J. Financ. Econ., 20:180-187. Baker HK, F arrelly E, Edelman RB (1985). A Survey of Management Views on Dividend Polic y. Financ. Manage., 14: 181-190. Baker HK, Theodore V, Powell E (2001). Factors influencing dividend policy decision of Nas daq Firms. Financ. Rev., pp. 19-38.