Payout Taxes and the Allocation of Investment

High payout taxes lock in capital at firms that generate internal cash flows.

Payouts of corporate earnings, whether in the form of dividends or share repurchases, are subject to taxation in most countries. Those taxes drive a wedge between the cost of internal equity finance, from retained earnings, and external equity finance, from new share issues. Higher taxes on corporate payouts are expected to "lock in" investment in currently-profitable firms that generate retained earnings, relative to firms with good investment opportunities that require external equity financing. Put differently, payout taxes favor investment financed by retained earnings over investment financed by equity issues.

In Payout Taxes and the Allocation of Investment (NBER Working Paper No. 17481), authors Bo Becker, Marcus Jacob, and Martin Jacob use an international dividend and capital gains tax dataset covering 25 countries during 1990-2008 to assess this "lock-in effect". Their data include 15 substantial tax reforms and 67 discrete changes in dividend or capital gains tax rates. They use this tax database to test if the allocation of investment across firms with and without access to internal equity depends on payout taxes.

The authors find that payout taxes do affect the allocation of capital across firms. High payout taxes lock in capital at firms that generate internal cash flows. If firms have different investment opportunities, this means that tax rates change the type of investments being made. For example, high payout taxes may favor established industries. The authors suggest that taxes on payout may be as important for investment decisions and the cost of capital as is the corporate income tax.

The authors also find that the effect of payout taxes is related to both access to the equity market and governance. Firms that can access the equity market are most affected by tax changes, because such tax reforms have an effect on the costs of raising equity. Firms that rely on retained earnings for equity finance are less affected by taxes. Governance also has an influence on investment decisions. Firms in which decision makers have low financial stakes are less affected by tax changes, reflecting their propensity to make investment decisions for reasons unrelated to the cost of capital.

--Lester Picker