Are Dividends and Share Buybacks Substitutes in a Tax-Free Environment? Evidence from the GCC

Abstract

Purpose: We test whether dividends and share buybacks are substitutes in a tax-free environment. Firms in recent decades substituted buybacks for dividends due to the low tax rates on capital gains. Investors in the Gulf Cooperation Council (GCC) countries do not pay taxes on cash dividends, making the substitution between dividends and buybacks less relevant.  
Study design/ methodology/approach: We use an empirical approach using the Lintner (1956) model to estimate future dividend surprises, and subsequently run cross-sectional regressions using Fama-Macbeth (1973) to compare predicted dividend surprises with actual dividends paid and share repurchases.
Sample and data: We collect data for firms headquartered in GCC countries from the World scope and DataStream databases, resulting in 8,729 firm-year observations spanning from 1993 to 2019.
Results: We find that the dividend changes are positively related to share buyback yield. Firms that have positive (negative) dividend surprises are associated with more (less) repurchases activity. Our results suggest that dividends and repurchases are complements rather than substitutes in a tax-free environment. It supports the findings that taxes play an important consideration when firms decide their payout policy.
Originality/value: This is the first paper that studies this substitution effect in payout policy in a tax-free environment.
Research limitations/ implications: Limitations include lack of data prior to 2003 and other data availability limitations. Implications include how firms may decide their optimal payout policy and how repurchase regulations are set in the GCC.

 JEL classification: G15, G35