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.