Productivity and payout policy

• Published date: 01 March 2023
• Author: Manoj Kulchania
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/eufm.12364

DOI: 10.1111/eufm.12364

ORIGINAL ARTICLE

Productivity and payout policy

Manoj Kulchania

Department of Finance, Mike Ilitch

School of Business, Wayne State

University, Detroit, Michigan, USA

Correspondence

Manoj Kulchania, Department of

Finance, Mike Ilitch School of Business,

Wayne State University, 2771 Woodward

Ave, Detroit, MI 48201, USA.

Email: manoj.kulchania@wayne.edu

Abstract

I investigate how a firm's total factor productivity

(TFP)isrelatedtoitspayoutpolicy.Ifindthat

firmswithhigherTFParemorelikelytopay

dividends and repurchase shares. Such firms also

pay higher dividends and repurchase more shares,

even after controlling for income and other factors

known to affect payout policy. Results are robust to

propensity score matching and other analyses,

including adoption of productivity‐enhancing

technology. I find that firms with higher TFP earn

higher future operating income; productive firms

with higher agency concerns pay back more,

thus draining resources that could potentially be

misused.

KEYWORDS

dividends, payout, productivity, repurchases

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Eur Financ Manag. 2023;29:588–633.wileyonlinelibrary.com/journal/eufm588

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I thank John Doukas (editor) and two anonymous referees for providing invaluable suggestions for improving the

paper. I also thank Ranjan D'Mello, Dharam Prakash Sharma, Mohan Sharma, Shawn Thomas, Chi Zhang and seminar

participants at the 2019 FMA conference for comments and suggestions. Min Jeong‐Kwon provided useful research

assistance. All errors remain my own.

1|INTRODUCTION

In 2018 alone, S&P 500 firms paid $450 billion in dividends and repurchased shares worth more

than $800 billion.

1

Many firm, industry and market factors are known to influence payout

policy.

2

While firm productivity is known to be a strong differentiator in how firms use

available capital, equipment and labour resources to marshal production and generate cash

flows, no study has linked firm productivity to payout policy. I aim to fill this gap.

The classical view of a firm as a ‘nexus of contracts’(e.g., Demsetz, 1988;Jensen&

Meckling, 1976) is that managers act as agents of shareholders and command (tangible and

intangible) assets, capital and labour to produce profits. In this process, firms have differing access to

capital and labour resources and operate in product markets exposed to different levels of

competition. However, two otherwise identical firms operating in the same industry and having the

same resources can produce vastly different outputs because of differences in their production

functions (Douglas & Cobb, 1928). In the classic Cobb–Douglas production function models, total

factor productivity (TFP) is the portion of output not explained by the classical inputs. Otherwise

identical firms using similar inputs but with different TFP may follow quite different trajectories.

Note that TFP is a different construct than profitability—TFP can fall while profitability rises

(because of production inefficiencies but higher output prices), just as TFP can rise while

profitability falls (because of artificially lower output prices).

3

It is generally agreed that TFP is a

broader gauge of performance than profitability or labour productivity alone. For a long time, TFP

was estimated at the economy level. Theoretical advances by Olley and Pakes (1996)and

implementation by İmrohoroğlu and Tüzel (2014)haveallowedfirm‐level TFP to be calculated using

a combination of firm characteristics and economy‐wide variables. While profitability has been

linked to payout policy, no extant study investigates whether TFP is related to payout policy.

Ex ante, the relation between productivity and payout is not clear. For instance, investment in

better machines or the adoption of caring labour policies might improve productivity and output

while also increasing costs, thereby reducing profits and payouts in the short run. If productivity

improvements are just enough to pay for the costs of improvements, the higher productivity may

not affect payout at all. Some improvements, e.g., innovations in research and development

(R&D), may push a firm down a path of required multiperiod investments requiring higher

plowback into the firm, resulting in lower payouts. Yet other improvements (e.g., innovations

leading to reductions in costs or improvements in sales revenue while keepingcosts constant) can

directly increase profits and payouts. Traditional constrained‐growth models may argue for

preserving liquidity (hence reducing payouts) for fast‐growing firms

4

; however, Feng et al. (2020)

1

See S&P News Release available at https://www.spindices.com/documents/index-news-and-announcements/

20190325-sp-500-buybacks-2018-q4-pr.pdf.

2

Firm factors (e.g., capital structure, cash holdings, cash flow, type of and variability of operating income), industry

factors (e.g., competition, unionization, behaviour of rivals), market‐related factors (e.g., recent price movements,

liquidity) and investor preference for a particular form of payout (e.g., catering), among other variables, are known to

affect payout policy (e.g., see Allen & Michaely, 2003; DeAngelo & DeAngelo, 2007; DeAngelo et al., 2008; Farre‐Mensa

et al., 2014; Baker & Wurgler, 2004; Kulchania, 2013).

3

Profitability specifically captures the part of revenue after taking care of costs of goods sold, interest payments, taxes

and depreciation. Productivity measures output produced from the given inputs of labour and capital, not just debt.

Generally, productivity is not affected by a change in input or output prices, while profit is. However, technical change

affects both productivity and profits. Labour productivity, by itself, is inadequate for capital intensive industries. See

Lieberman and Kang (2008) for a case study giving examples of differences between profitability and TFP.

4

See Restuccia and Rogerson (2013) for a literature review.

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suggest that the average firm in an unconstrained economy might actually need less cash

reserves, with the option of raising more asneeded. While we know that capital policies (e.g., see

Hovakimian et al., 2001), labour awards and bargaining (e.g., see Chen et al., 2015;He

et al., 2015) affect payout policy individually, whether benefits from improvement in the use of

resources—as captured by productivity—affect payout policy remains an unanswered empirical

question.

To study this relation, I follow the İmrohoroğlu and Tüzel (2014) method to calculate

annual firm‐level TFP for a sample of US firms in the Compustat database for the period

1986–2017 and investigate how TFP affects payout policy. I find that firms with higher TFP are

more likely to pay or initiate dividends and to repurchase shares. Ceteris paribus, as a firm

moves from the 25th to the 75th percentile of TFP, the probability of paying dividends

(repurchasing shares) increases from 27% to 33% (55%–65%), which is a significant 22.2%

(18.2%) increase. In line with İmrohoroğlu and Tüzel, I also find that firms in the highest

quartile of TFP have more cash, less debt and a higher market‐to‐book (M/B) ratio.

Higher TFP not only increases the probabilitythatafirmwillpayitsshareholders,but

it also increases the amount paid. After controlling for industry and firm factors known to

affect payout policy, as a firm moves from the 25th to the 75th percentile of TFP the

average firm's dividend payout increases by 1.96% of total assets—representing a 24.5%

increase in the average firm's dividend payout. For a similar change in TFP, share

repurchases increase by 0.35% of total assets—representing a 25.2% increase in the

average firm's share repurchases. I also find that the annual change in payout is related to

the annual change in TFP. Interestingly, TFP volatility is also related to payout policy—

while firms with more volatile TFP appear less likely to pay dividends and repurchase

shares, the amounts spent on dividends (repurchases) are negatively (positively)

associated with TFP volatility. Recent evidence from Kulchania (2016) and Michaely

et al. (2020) suggests that cash flow volatility may be related to payout policy; our results

yield evidence that TFP volatility may also be related to payout policy.

Next, I test the possibility that the results may be picking up the effect of remote

factors correlated with productivity and payout policy. Productivity is clearly endogenous

to many other firm characteristics. To tackle this important issue, I take a multipronged

approach. First, I use a propensity score matching approach to find the nearest neighbour

of an above‐median TFP firm from among similar firms, but that has a below‐median TFP.

I find that firms with above‐median TFP spend more on dividends and share repurchases

compared to otherwise similar firms with lower TFP. This finding is robust across

different matching techniques, for example, the calliper of 0.3 or four nearest‐neighbour

matches. Second, I determine how firm payout behaviour changes when a firm suddenly

improves TFP. I find that firms spend more on payout (both dividends and share

repurchases) when they suddenly transition to a higher TFP.

As an additional test to determine how payout changes around productivity shocks,

I look at firm decisions to adopt a just‐in‐time (JIT) inventory management technique.

Adoption of JIT, generally in manufacturing‐oriented firms, is known to enhance

productivity through continuous improvements in processes and elimination of waste in

inventory holdings (Crawford & Cox, 1990; Lummus & Duclos‐Wilson, 1992;

Suzaki, 1987). While acknowledging that the decisiontoadoptJITisnotcompletely

exogenous, I examine the adoption of JIT as a precise event that enhances firm

productivity and test how payout policy changesaroundthisadoptioninadifference‐in‐

differences setting. I find that firms increase dividend payouts and share repurchases after

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