Dividends and Taxes

How do dividend taxes affect firm behavior and what are their distributional and efficiency effects? To answer these questions, the first problem is coming up with an explanation for why firms pay dividends, in spite of their tax penalty. This paper surveys three different models for why firms pay dividends, and then uses each model to examine the behavioral and efficiency effects of dividend taxes. The three models examined are: the “new view,” an agency cost explanation, and a signaling model. While all three models forecast dividends, their forecasts regarding other firm behavior, and their forecasts for the efficiency and distributional effects of a dividend tax, often differ. Given the evidence to date, we find the agency model is the one most consistent with the data. Under this model, the efficiency effects of a dividend tax largely depend on the difference between the tax rates on dividends and capital gains, with the further complication that agency costs generate too much investment in the corporate sector. The objective of this paper is to provide an overview of the existing debate about the behavioral and efficiency effects of taxes on dividends. The tax treatment of dividends differs widely across countries and has changed dramatically since 2001 in the U.S. What difference does this make? In order to be in a position to assess how dividend taxes affect behavior and efficiency, we first need to provide an explanation for why firms pay dividends, in spite of their unfavorable tax treatment. Certainly firms need to provide a payoff to their equity holders. But providing this return through dividends has in the past subjected their shareholders to higher tax liabilities than they would face if the funds for example were used instead to repurchase shares in the firm, reinvested in productive assets, or used to acquire other firms, in each case generating income for shareholders that is taxable as capital gains. Section 1 briefly describes this longstanding dividend puzzle. * This paper was written for the David Bradford Memorial Conference, held at NYU Law School on May 5, 2006. We would very much like to thank George Zodrow, William Andrews, and the other participants for comments on an earlier draft. Dietz thanks the Fritz-Thyssen-Stiftung for financial support.