The Effect of Dividends on Consumption

Microsoft's $32 billion cash dividend of December 2004 was the largest corporate payout ever. Classical models of finance and consumption-saving decisions predict that this dividend will have little effect on the consumption of Microsoft investors. Under the assumptions of Merton Miller and Franco Modigliani, for example, investors can always reinvest unwanted dividends, or sell shares to create homemade dividends, and thereby insulate their preferred consumption stream from corporate dividend policies.¹ Thus, in traditional models, the division of stock returns into dividends and capital gains is a financial decision of the firm that has no "real" consequence for investor consumption patterns.

Yet there are a number of reasons to think that dividend policy, and dividends more generally, may indeed affect consumption. Most obviously, the popular advice to "consume income, not principal" suggests a potentially widespread mental accounting practice in which investors do not view dividends and capital gains as fungible, as in the homemade dividends story and traditional theories of consumption, but rather place them into different mental accounts from which they have different propensities to consume.² This behavior is also consistent with a belief that dividends, unlike capital gains, represent permanent income. Less exotic but equally realistic frictions, such as transaction costs (of making homemade dividends) and taxes, can also lead an investor to favor consuming dividends before capital appreciation.

Although the dividends-consumption link is a potentially fundamental one between corporate finance and the real economy, little empirical research has pursued the issue. The reason is probably that the most easily available data on consumption and dividends are aggregate time-series data, which have several limitations. Among other challenges, such data require one to identify the effect of a smooth aggregate dividend series using a small number of data points; they combine investors and noninvestors; and they face an essentially prohibitive endogeneity problem: omitted variables such as business conditions will jointly affect consumption, dividends, and capital appreciation, making it difficult to establish the causality behind any observed correlations.

This paper studies the effect of dividends on investor consumption using two micro data sets that reveal and exploit powerful cross-sectional variation in dividend receipts and capital gains. The first is the Consumer Expenditure Survey (CEX), which is a repeated cross section with data on expenditure measures and self-reported dividend income and capital gains (or losses). Our CEX sample includes several hundred households per year between 1988 and 2001. The second data set includes the trading records of tens of thousands of households with accounts at a large discount brokerage from 1991 through 1996.³ Although these portfolio data do not contain an explicit expenditure measure, they complement the CEX by allowing us to accurately measure net withdrawals from the portfolio, a novel dependent variable in its own right and a precursor to expenditure. The data set also allows us to measure the withdrawal rates of different types of dividend income, including ordinary, special, and mutual fund dividends, which allows for finer comparisons.

We start with an analysis of the CEX data. Our most basic approach is to regress consumption on realized dividend income, controlling for total returns including dividends. The coefficient on dividend income thus captures differences between the consumption responses to dividends and to capital gains. We find that the coefficient on realized dividend income for total consumption expenditure is large, positive, and significant. This basic result is robust to a variety of control variables and estimation techniques, including specifications in first differences. It suggests that, contrary to classical models, the form of returns does matter for consumption.

We then use the brokerage account data in an effort to test the mechanism behind this effect; that is, we test whether dividends are indeed withdrawn from the household portfolio at a higher rate than capital gains. The data strongly confirm this. On average, investors do not reinvest ordinary dividends: the propensity to withdraw modest levels of ordinary dividends is unity. A fraction of mutual fund and special dividends is also withdrawn. On the other hand, very large dividends of any type are not fully withdrawn...