Taxable Cash Dividends - a Useful Waste of Money

Firms pay out cash using dividends and share repurchases. These two ways are similar in many aspects but one important difference is that dividends are generally taxed more heavily than share repurchases. Nevertheless large amounts are paid out in dividends. This paper provides a new explanation for this puzzle. The paper assumes a signaling model with asymmetric information between the management and the shareholders about the quality of the firm. In this model a high-quality firm can always signal its quality using only share repurchases. However, in certain cases share repurchases becomes more costly on the margin for the high-quality firm than for a low-quality firm. In such cases, the high-quality firm will signal by means of a combination of share repurchases and taxable cash dividends financed by the issuance of new shares and hence, taxable cash dividends are a kind of money burning. The implications of the model are consistent with several important empirical facts about dividends.