Carrots and sticks
Dividend policy and corporate strategy of multinational corporations
What benefits does profit sharing through dividends bring to an international firm?
Three main factors determine the dividend policy: taxes, PR and host-country realpolitik. Although researchers have long been covering how sensitive the optimal ratio of dividends to earnings ratio is to international tax rates and corporate governance, no single model puts all three issues in the context of international economics.
We can say, however, what a comprehensive model like this must address in the first place.
Economic policies often force companies to pay low dividends. Repatriation taxes — one-time taxes on past profits of foreign subsidiaries — are one of the reasons. For example, Desai et al have shown that repatriation taxes caused a fall of 13 percent in aggregate US dividends between 1982 and 1997.
But reducing dividends may bring about direct tax benefits as well.
Most high-income OECD countries allow multinational firms to defer payment of liabilities on income originating from overseas until the remission of funds as dividends. Some countries provide tax credits for taxes paid abroad.
This incentivizes firms to reinvest the capital into the host economy. Since multinational companies can also pick affiliate transfers or investment into passive assets, governments have been striving to introduce stronger measures for covering account deficits and speeding up FDI inflows.
The Homeland Investment Act is an example of such a measure, a temporary tax holiday passed by the US Congress in 2004 in hopes of creating more than 0.5 million jobs over two years by raising investment in the US. This increased the amount of repatriations from the average of $62 billion per year from 2000 to 2004 to $299 billion in 2005, which fell back to $102 billion in 2006, resulting in the total $362 billion repatriated.
Despite the increase and explicit ban of distributing the repatriated funds among the shareholders, each $1 increase in repatriations resulted in only a 1 cent increase in domestic investment and 15 cent increase in dividends. Most of the rest went into attempts of solidifying the market power via share repurchases.
Shareholders endow the firm with the capital and trust that the capital will multiply. Dividends in this sense provide social proof for the sensibility of the investment: steady payments build up the rapport.
Nevertheless, dividends are a double-edged sword. Even though high dividends can signal the fundamental strength and sustainability of the company, such policies may also point to the lack of significant points of growth inside the company, hurting the long-term outlook of growth. If a firm with a track record of dividend payment decides to curb the policy, it may send a signal of trouble to the market and see the stock crash. When General Electric Co announced a 50% decrease in dividends, shareholders suffered a decline of more than seven percent in the stock price on November 13, 2017.
These considerations led Lintner to formalize a model that explains the fact why dividends of successful companies stay stable and smooth year on year and how to design a maintainable dividend policy.
The management of multinational companies, however, is complicated with multiple investor biases that make balancing dividends with stock returns more challenging:
- International operations of multinational companies have lesser sentimental value than domestic operations in the valuation of stock.
- Investors believe that international operations have higher sunk costs, and thus judge a decrease in the dividend payouts from foreign operations more harshly.
Dividends also serve as a yardstick for the effectiveness of the management. Excessive accumulation of capital often leads to oversized executive compensation and mediocre allocation of resources. For example, the more cash the company holds onto, the more likely it will overpay for acquisitions, damaging the shareholder value.[8:1] And when the host country lacks strong courts, or when the subsidiary has a shared ownership structure, multinational companies in the US repatriate profits more often, despite the tax consequences[1:1].
Political risk, tax rates, country growth rates and currency crises all affect the design of dividend policies, but the decision-making varies a lot among the nations, as discussed by Lehmann and Mody.
The authors analyzed the income and dividend data for the United Kingdom, the United States and Germany, and obtained the following results:
- The payout ratio of dividends declines with greater political stability in the UK. The effect is less pronounced in the US and Germany.
- Higher tax rates raise the payout ratios in the UK and Germany, but not in the US.
- When growth is high, dividends grow in the UK, but not in the US or Germany, where companies prefer to reinvest in the host economy.
The interpretation of the differences in the dividend patterns is speculative, which pinpoints the importance of the agency problem in the operations of a multinational enterprise: how should managers at the headquarters control decision-making abroad?
Over time, cash dividends as a principal component of the investment portfolio has been losing prominence: wherever buybacks are legal, share repurchases have become a major instrument for distributing profits to stockholders.
Nevertheless, a sound dividend policy is still crucial to the long-term success of a company: it builds trust, signals the real value of the enterprise, allows to reduce uncertainty due to excess capital and provides a leverage for optimizing taxes. No wonder that firms, investors and analysts devote so much money and attention to dividends.
Creating an appropriate payout policy involves careful balancing of multiple potentially adversarial forces: taxes and brand value on the one hand, and financial sustainability and managerial sense-making on the other.
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Desai, Mihir A. & Foley, C. Fritz & Hines, James R. Jr., 2001. Repatriation Taxes and Dividend Distortions. National Tax Journal, National Tax Association; National Tax Journal, vol. 54(4), pages 829-851, December. ↩︎
Altshuler, R., Grubert H., 2003. Taxes, repatriation strategies and multinational financial policy. Journal of Public Economics 87, 73-107. ↩︎
Dhammika Dharmapala & C. Fritz Foley & Kristin J. Forbes, 2011. "Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act," Journal of Finance, American Finance Association, vol. 66(3), pages 753-787, 06 ↩︎
J. Chen, Dividend, Investopedia, 04-Dec-2019. [Online]. Available: https://www.investopedia.com/terms/d/dividend.asp. [Accessed: 10-Dec-2019] ↩︎
Lintner, J. 1956. Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes. The American Economic Review, 2, 97-113. ↩︎
Christophe, S.E., Pfeiffer, R.J. 2002. The Valuation of MNC International Operations During the 1990s. Review of Quantitative Finance and Accounting 18, 119–138 doi:10.1023/A:1014513001321 ↩︎
Ji-Yub (Jay) Kim, Jerayr (John) Haleblian and Sydney Finkelstein. Administrative Science Quarterly, Vol. 56, No. 1 (March 2011), pp. 26-60 ↩︎ ↩︎
Lehmann, Alexander and Mody, Ashoka, A. 2004. International Dividend Repatriations. IMF working paper WP04/04. ↩︎
Baker, H. & Weigand, Robert. (2015). Corporate dividend policy revisited. Managerial Finance. 41. 126-144. 10.1108/MF-03-2014-0077. ↩︎