Personal Income Tax and Corporate Investment

Murray Z. Frank, Rajdeep Singh and Tracy Yue Wang

This version: October 13, 2009

ABSTRACT

Existing studies report that the 2003 dividend tax cut had no effect on corporate

investment. In this paper we show that dividend taxation, in theory should have,

and empirically does have, important effects on corporate investment among pub-

licly traded U.S. firms from 1977 to 2006. Cash-poor firms respond to a dividend

tax cut by increasing investment. Cash-rich firms respond to a dividend tax cut by

reducing investment and increasing dividends. The opposite reactions from these

two types of firms significantly reduce the observed aggregate or average response

of firms’ investment to dividend tax changes.

JEL classification: G31, G32, H24.

Keywords: corporate investment, dividend taxation, personal income tax, tax over-

hang, dividend capitalization.

The authors are at the Carlson School of Management, University of Minnesota. Contact: Murray Frank:murra280@umn.edu; Raj Singh: rajsingh@umn.edu; Tracy Yue Wang: wangx684@umn.edu. We wouldlike to thank seminar participants at Simon Fraser, University of Minnesota, the 4th FIRS Conferenceon Banking, Corporate Finance and Intermediation, and the 2008 European Summer Symposium inFinancial Markets in Gerzensee Switzerland. We also thank Richard Arnott, Alan Auerbach, ReintGropp, Thomas Hellmann, Josh Lerner, Vojislav Maksimovic, Jack Mintz, and Clemens Sialm for helpfulcomments. As usual, all mistakes are ours.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 significantly cut the tax

rate on dividend income for individuals. Since the tax cut increased the investment returns

from an investor’s point of view, the Act was expected to stimulate corporate investment.

However, in a study of this issue Desai and Goolsbee (2004) found that the tax reform

did not generate the expected investment. “The evidence ... suggests that the dividend

tax reductions enacted in 2003 had little or no effect on investment.” Their study calls

into question the empirical importance of dividend tax effects on corporate investment.

If tax cuts had no effect on corporate investment, then perhaps tax increases scheduled

for 2010 (when “the Bush tax cuts” expire), will also not have much effect on corporate

investment. Furthermore, if dividend taxes do not affect corporate investment, then

perhaps some reconsideration of the corporate finance theory about the cost of capital is

necessary.

This paper shows that in fact, dividend taxation has empirically important effects

on corporate investment. To understand the tax effect, it is crucial to recognize cross-

sectional differences in firms’ responses to personal tax changes. The cross-sectional dif-

ference under study is due to the cash position that each firm inherits from past retained

profits. For our purposes the past profits could equally be due to luck or good past de-

cisions. Either way a firm that has a profitable history is likely to be cash-rich. A firm

without a profitable history will be cash-poor. The cash-rich firm being on the distri-

bution margin can finance investment using retained earnings, while the cash-poor firm

being on the financing margin must raise funds if it is to invest. As a result, even if facing

the exact same real investment opportunity, these firms may make different decisions.

To motivate the empirical analysis, we develop a simple illustrative model to show

how personal taxes affect the firm’s incentive to invest. For a firm that needs to raise

new funds in order to invest (‘cash-poor’), there is the conventional impact of double

taxation, which raises the cost of investing. However, for a firm that has enough retained

earnings (‘cash-rich’) there are other effects. By reinvesting profits within the firm, the

firm’s investors are able to defer personal taxes in much the same way as in a tax deferred

savings account. We call this the tax-overhang effect. It is related to the tax-free wealth

accumulation in life insurance analyzed by Miller and Scholes (1978). The reinvestment

1

may also be associated with more beneficial tax treatments through an effect that we call

the dividend-capitalization effect. By investing retained earnings the firm may convert

investors’ dividend tax liabilities to capital gains liabilities.1

These two tax effects for the cash-rich firm work in the opposite direction from the

double-taxation effect. Thus in comparison to a personal-tax-free first-best investment

rule, the cash-poor firm tends to underinvest, while the cash-rich firm tends to overin-

vest. A dividend tax cut reduces both distortions, moving both types of firms closer to

the first best. The cash-rich firm tends to respond to a dividend tax cut by increasing

payout and reducing investment. The cash-poor firm tends to respond by increasing in-

vestment financed by newly raised funds. In the aggregate the two opposite reactions

can significantly reduce the observed response of firms to tax cuts and can even make it

insignificant.

The empirical work focuses on the impact of dividend tax cuts on corporate investment

rather than dividend payout.2 Using the dividend tax rates and the capital expenditures

of U.S. publicly traded companies from 1977 to 2006, the implications of the model are

tested. Cash-richness is empirically important. When this is taken into account there is

strong evidence that dividend taxation has a first order effect on corporate investment.

As predicted by the model, a cash-rich firm and a cash-poor firm react in opposite ways to

a dividend tax change. There is also evidence that potential startup firms, an important

example of cash-poor firms, behave in a way consistent with our model implication. New

business formation surged in the U.S. following the 2003 dividend tax cut.

1The idea that the financing margin matters is not new to our paper. The influential study of Hennessyand Whited (2005) examines the impact of this distinction on corporate capital structure.

2Investment seems to be a key concern for policy makers. For example, the impetus for the stimulusbill of 2009 came from a desire to spur investment in the economy. Academics have also similar concerns.Auerbach and Hassett (2009) argue that there is a need for further study of the impact of the 2003dividend tax change on corporate investment. Moreover, the empirical effect of dividend taxes on dividendpayments that are observed is not too surprising. Similar results have been documented by Chetty andSaez (2005) and others for the 2003 dividend tax cut. Blouin et al. (2004) provide a number of caveats,including the important observation that Fisher Black’s (1976) dividend puzzle remains true both beforeand after the tax change in 2003. Dharmapala (2009) provides a valuable up-to-date review of thatliterature. Going beyond 2003 we show that the effect of dividend taxes on dividend payments is actuallyfairly general.

2

A rich set of tests are performed to ensure the effectiveness of the empirical identifi-

cation strategy. We show that changes in dividend taxes are not proxying for systemic

changes in personal income taxes or other confounding events. Firms that have a larger

fraction of shares held by tax-exempt investors exhibit, as expected, weaker dividend tax

effects on investment. Cash-rich dividend payers significantly increase dividend payout

following dividend tax cuts, while cash-poor dividend payers do not. Further, the the-

ory implies that the differing dividend tax effects on cash-rich firms and cash-poor firms

should weaken among firms with high debt capacity. This is supported by the data.

The results are also quite robust. Using alternative definitions of cash-richness and

examining longer-horizon changes in investment leave the key results unchanged. When

the entire time-series is studied the effects found for the sub-sample of large notable tax

changes continue to hold. Not surprisingly, the effects are larger when the tax changes

themselves are larger. We also extend the analysis to incorporate competition between

firms with similar or different cash positions. Industries with both cash-poor and cash-rich

firms exhibit significantly larger investment responses to dividend tax cuts than industries

with mostly cash-poor (or mostly cash-rich) firms.

Given that the effects are significant, and appear to be reliable, it becomes of interest

to ask whether the effects are large enough to be important. Consider a dividend tax cut

similar in magnitude as the one in 2003. That is a 14.3 percentage point reduction in

the marginal dividend tax rate. According to the base-line estimates, a cash-poor firm

with one billion dollars of assets will on average increase its capital expenditures by $13

million, while a same-size cash-rich firm will on average decrease its investment by $15

million. In our sample the average annual capital expenditures of firms with about one

billion dollars of assets is $73 million. Therefore, the estimated changes in both types

of firms’ capital expenditures due to the tax cut are economically significant. However,

the estimated change in the aggregate investment in 2003 due to the dividend tax cut is

only 0.8% of the aggregate corporate assets, consistent with the flat investment response

documented in other studies.

The rest of the paper is structured as follows. Section I builds a simple model to

illustrate how personal taxes affect the firm’s investment incentive. Section II develops

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the hypotheses and the empirical design based on the model implications. Section III

presents the empirical analysis. Section IV discusses the related literature. Section V

concludes.

I. The Model

The purpose of this section is to clarify the basic forces that will be tested empirically.

We start with a particularly simplified situation in which all corporate distributions are

taxed at the personal level at the same rate.3 This provides a sharp illustration of the tax-

overhang effect. Then the possibility of investors getting a more beneficial tax treatment

is modelled. To do this a more realistic version of the tax code is studied which accounts

for differing dividend tax and capital gains tax rates. This permits the issue of dividend

capitalization to arise.4

Consider the investment problem of a firm that maximizes the investor’s welfare. There

is no agency issue. Capital is perfectly divisible and does not depreciate. There are three

dates that represent the past t = 0, the present t = 1, and the future t = 2.

∙ At t = 0, the firm raised B dollars from the investor and invested in a long term

(two-period) project. This is called the original project.

∙ At t = 1, the original project either had a successful first period (net profit of

�1 > 0) or an unsuccessful first period (net profit of 0). If the firm has a positive

cash balance from a successful first-period operation, it is called a cash-rich firm. If

3Our framework is similar in spirit to the model in section I of Hennessy and Whited (2005) in thatboth they and we are concerned about whether money is better left in the firm, or in the hands of theinvestor. Hennessy and Whited (2005) study the debt versus equity choice. In contrast, we assume noflotation costs, we study investment decisions rather than capital structure decisions, and we allow forcapital gains taxation. As a result, while there is some similarity, the key results are different.

4Our analysis abstracts from a whole host of potentially interesting issues such as optimal payoutpolicy, optimal capital structure, optimal cash retention, managerial agency, tax or liquidity motivatedtrading, optimal tax policy etc. Many of these could provide valuable deeper insights and qualifications towhat we have found in the current study. In an interesting recent working paper Chetty and Saez (2007)study the impact of agency conflicts to explain corporate reactions to dividend tax changes. They arguethat dividend taxation can exacerbate an under-monitoring problem. In contrast, our analysis sticks tothe traditional setting in which managers operate in the best interests of the investors.

4

the firm has zero cash balance as a result of an unsuccessful first-period operation,

then it is called a cash-poor firm.

∙ At t = 2 the original project has a net profit of �1 > 0 for sure. After this period’s

profits are realized, the firm stops operations and returns the capital to the investor.

The key decision for the firm takes place at date t = 1. Irrespective of the cash balance,

at date t = 1 the firm has a decreasing returns to scale investment opportunity with a

net profit of � (I), where I is the amount invested. The Inada conditions are assumed to

be satisfied. Specifically, �′ (⋅) > 0, �′′ (⋅) < 0, �′ (0) =∞ and �′ (∞) = 0. The investor’s

alternative investment is simply depositing money in a bank. At t = 1 the investor has

capital K invested in the bank. The bank pays a scale-independent riskless rate of return

denoted r.

The cash-rich firm is at the distribution margin. It can either pay out the first-period

operating profits, or reinvest the profits in the new project. In contrast, the cash-poor

firm is at the equity-financing margin. It can either stand pat with the existing capital,

or raise new equity capital from the investor to invest in the new project.5

The tax code treats various corporate cash flows in different ways. Let �c be the

corporate level tax on profits, �d be the personal tax on dividends, �g be the personal tax

on capital gains, and �i be the personal tax on interest income from the bank.

A. Personal Tax Overhang Effect

We start by assuming that given a firm’s payout regime, all cash paid out by the firm

will be taxed at the same personal tax rate for equity, �e = t (�d, �g), where ∂t∂�d

> 0 and

∂t∂�g

> 0. At t = 2 the firm liquidates and the investor gets to deduct her basis before the

personal tax is levied. The distinction between dividend taxes and capital gains taxes is

considered in the next section.

5We discuss the impact of debt financing in Section III.C.3. Also, given that the firms will ceaseto exist after one period, there is no role of conserving cash for the future. Due to double taxation atthe corporate level, investing in the bank by the firm is dominated by investing by the investor on herpersonal account.

5

The Cash-Poor Firm:

The cash-poor firm has no internal cash from past operations. Suppose that at t = 1

the cash-poor firm raises IP dollars from the investor and invests in the new project. At

t = 2, the firm pays out its after-corporate-tax earnings (1− �c) [�1 + � (IP )], liquidates

its capital, and returns B + IP to the investor. The tax basis of the investor is also

B+ IP . The investor, at t = 1 also has (K − IP ) dollars invested in the bank. Hence, the

investor’s wealth at t = 2 is given by

VP = (K − IP )︸ ︷︷ ︸Bank Deposit

[1 + r (1− �i)] + [(1− �c) [�1 + � (IP )] +B + IP ]︸ ︷︷ ︸Firm’s t=2 Payout

− �e

⎛⎝ Payout︷ ︸︸ ︷(1− �c) [�1 + � (IP )] +B + IP −

Tax Basis︷ ︸︸ ︷(B + IP )

⎞⎠︸ ︷︷ ︸

Personal tax at t=2

The firm maximizes the investor wealth VP by choosing IP . The first order condition

is given by

∂VP∂IP

= − (1 + r (1− �i)) + (1− �e) (1− �c) [�′ (Ip)] + 1 = 0. (1)

The firm invests to the point at which the after-tax return of investment is equal to the

after-tax cost of capital. Solving the first order condition gives,6

�′ (Ip) =r (1− �i)

(1− �e) (1− �c)≡ �P . (2)

The interpretation of �P is quite natural. In (2) the term �P is the marginal pre-tax

required rate of return. The cash-poor firm invests until the point at which its pre-tax

return from investment is equal to �P . The taxes on interest income (�i), equity income

(�e), and corporate profits (�c) all affect the optimal scale on which the cash-poor firm

invests.

6 The Inada conditions insure that there exists an interior solution to the FOC. The second ordercondition is clearly satisfied as ∂2VP

∂I2P= (1− �e) (1− �c)�′′ (Ip) < 0. Hence, the solution to the FOC is

the maxima.

6

The Cash-Rich Firm:

The problem for the cash-rich firm is similar to that of the cash-poor firm. The main

difference is that the cash-rich firm’s cash balance at t = 1 is assumed to be high enough

so that the firm does not need to raise fresh capital to invest. Instead the firm must decide

how much money, if any, to return to the investor.

The cash-rich firm has earnings at t = 1, and it pays corporate tax of �c�1. The firm

invests IR dollars and returns rest of the earnings (1− �c) �1 − IR to the investor. At

time t = 2 the firm first pays corporate taxes and pays out (1− �c) [�1 + � (IR)] to the

investor. The firm also liquidates its capital (B + IR) and returns this to the investor.

The investor has a basis of B. Accordingly the investor’s wealth at t = 2 is given by

VR =

⎡⎣ Bank Deposit︷ ︸︸ ︷(1− �e) [(1− �c) �1 − IR]︸ ︷︷ ︸

After tax t=1 dividend

+K

⎤⎦ [1 + r (1− �i)] + [(1− �c) [�1 + � (IR)] +B + IR]︸ ︷︷ ︸Firm’s t=2 Payout

− �e

⎛⎝ Payout︷ ︸︸ ︷(1− �c) [�1 + � (IR)] +B + IR −

Tax Basis︷︸︸︷B

⎞⎠︸ ︷︷ ︸

Personal tax at t=2

.

The first order condition for this problem is given by

∂VR∂IR

= (1− �e) (1− �c) �′ (IR) + (1− �e)− (1 + r (1− �i)) (1− �e) = 0 (3)

Concavity of � (⋅) is again sufficient to satisfy the second order condition. The firm invests

until its after-tax return of investment is equal to the after-tax cost of capital. Solving

the first order condition gives,

�′ (IR) =r (1− �i)(1− �c)

≡ �R. (4)

Here �R is the cash-rich firm’s marginal pre-tax required rate of return.

The basic difference between the cash-rich firm’s and the cash-poor firm’s marginal

conditions is clear. The personal tax rate on equity does not affect the marginal condition

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of the cash-rich firm. In the next section it will be shown that this simplification does

not carry over, under reasonable conditions, to the case in which there is a distinction

between dividend taxes and capital gains taxes.

The Impact of Tax Changes on Firm Investment

A key purpose for the analysis is to clarify the differing impact of personal tax changes

on the investment incentives of the cash-poor and the cash-rich. The firm’s optimal level

of investment is determined by its investment opportunity set and the required rate of

return derived above.

Let the firm’s optimal investment for the cash-poor and the cash-rich firms respectively

be denoted by I∗P and I∗R. These are determined by solving,

�′ (I∗P ) = �P ; �′ (I∗R) = �R (5)

The different investment incentives of the cash-poor firm and the cash-rich firm arise from

the difference in their marginal required rate of return (�P − �R ≡ Δ�).

Δ� =r (1− �i) �e

(1− �e) (1− �c)> 0 (6)

The intuition can be described fairly simply. If the cash-poor firm invests $1 at t = 1,

the opportunity cost from the investor’s point of view is the after-tax bank interest forgone

given by r (1− �i). For the cash-rich firm, by investing $1 the firm’s investor avoid paying

dividend taxes of �e at t = 1. Hence, the direct opportunity cost for the after-tax interest

forgone is given by r (1− �i) (1− �e). This difference is what we refer to as the personal-

tax-overhang effect. It comes from the cash-rich firm’s ability to defer the investor’s

personal tax liabilities. The personal-tax overhang effect is conceptually very similar to

the advantage obtained by popular tax-deferred investments such as 401-K accounts.

The model helps guide the main empirical tests to follow. Empirically the point is

to compare the investment responses of cash-rich firms and cash-poor firms to changes

in the dividend tax rate. The model’s prediction for these investment responses depends

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on how the pre-tax required rate of return changes with respect to the change in the tax

rate. The model implies that

∂�P∂�d

=∂�P∂�e

∂�e∂�d

=

(r (1− �i)

(1− �e)2 (1− �c)

)∂�e∂�d

> 0

∂�R∂�d

=∂�R∂�e

∂�e∂�d

= (0)∂�e∂�d

= 0.

A cash-poor firm’s pre-tax required rate of return is increasing in the dividend tax

rate. This is due to double taxation on corporate profits. For every $1 of dividend paid at

t = 2 the investor only gets (1− �e). Hence, the cash-poor firm requires a higher pre-tax

return from its investment as the personal tax rate increases.

The cash-rich firm is also subject to double taxation. However, there is an offsetting

force in the case of the cash-rich firm that is absent in the case of the cash-poor firm. The

current earnings has already accrued a tax liability. By investing the retained earnings the

firm helps the investor defer the tax liability. This accrued tax-liability is the basis of the

tax overhang. Thus, an increase in the personal tax rate reduces the after-tax return from

investment but also increases the benefit of tax deferment in the same proportion. The

two effects exactly cancel out, resulting in no net change in the required rate of return.7

The above discussion is summarized in the following proposition.

Proposition 1 The cash-rich firm’s optimal level of investment is greater than that of

the cash-poor firm (I∗R > I∗P ). The cash-poor firm’s optimal investment is decreasing in

the dividend tax rate (∂I∗P∂�d

< 0). The cash-rich firm’s optimal investment is independent

of the dividend tax rate (∂I∗R∂�d

= 0).

Proof: I∗R > I∗P results from �R < �P and the concavity of �(I).

∂I∗P∂�d

=∂I∗P∂�P

∂�P∂�d

. Equation (5) implies that∂I∗P∂�P

= 1�′′(I)

< 0. Since ∂�P∂�d

> 0,∂I∗P∂�d

< 0.

Similarly,∂I∗R∂�d

=∂I∗R∂�R

∂�R∂�d

= 0 because ∂�R∂�d

= 0. This completes the proof.

7The comparative statics of �P and �R with respect to �c and �i are straightforward and intuitive.∂�P

∂�c= r(1−�i)

(1−�e)(1−�c)2> 0; ∂�R

∂�c= r(1−�i)

(1−�c)2> 0; ∂�P

∂�i=− r

(1−�e)(1−�c) < 0; and ∂�R

∂�i=− r

(1−�c) < 0.

9

The results so far imply that following a dividend tax cut, there should be no effect on

the investment by cash-rich firms but an increase in the investment by cash-poor firms.

B. Dividend Capitalization Effect

In practice the distinction between dividend taxation and capital gains taxation can

be important. How much of an effect will this have on the analysis? It depends on

how firms behave. Unfortunately there is no fully accepted theory of either corporate

dividend policy, or of corporate financing policies.8 Thus we make simple assumptions

that are consistent with the intent of the tax code. According to Spilker et al. (2009),

“The tax law defines a dividend as any distribution of property made by a corporation to

its shareholders out of its earnings and profits (E&P) account.”9 Thus, we assume that

the payout that arises from periodic earnings is subject to the dividend taxation (�d). The

payout that arises from liquidated capital is subject to the capital gains taxation (�g).

The Cash-Poor Firm

The analysis is very similar to what came before. The cash-poor firm invests IP at

time t = 1. At t = 2, the after-tax earnings from the original project and the new project

are paid out as dividends. Also at t = 2, the capital invested in both projects, B + IP ,

is recovered and returned to the investor. As in the US tax code we assume that the

8For recent a survey of corporate dividends and share repurchases, see Kalay and Lemmon (2008).For a recent survey of capital structure, see Frank and Goyal (2008). These are both large literatures.To explore either would be well beyond the scope of our current study.

9 A detailed discussion of the tax issues is provided by Spilker et al. (2009, chapter 18). Precisedefinitions of distributions that are considered dividends can be obtained from the U. S. Code, Title26.§316, entitled ‘Dividend Defined’, which reads in part:

“For purposes of this subtitle, the term ‘dividend’ means any distribution of propertymade by a corporation to its shareholders— (1) out of its earnings and profits accumulatedafter February 28, 1913, or (2) out of its earnings and profits of the taxable year (computedas of the close of the taxable year without diminution by reason of any distributions madeduring the taxable year), without regard to the amount of the earnings and profits at thetime the distribution was made.”

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distribution of liquidated capital is treated as a capital gain. The tax basis of the investor

is also B + IP . Hence, the investor’s wealth at t = 2 is given by

VP = (1− �d) (1− �c) [�1 + � (IP )]︸ ︷︷ ︸After-tax dividend

+ B + IP︸ ︷︷ ︸Return of Capital

+ (K − IP )︸ ︷︷ ︸Bank Deposit

(1 + r (1− �i)) .

The first order condition is given by

∂VP∂IP

= (1− �d) (1− �c) [�′ (Ip)] + 1− (1 + r (1− �i)) = 0. (7)

The first order condition is exactly the same as in equation (1). Solving it gives,

�′ (Ip) =r (1− �i)

(1− �d) (1− �c)≡ �P . (8)

Note that the cash-poor firm’s marginal required rate of return is not affected by allowing

the dividend tax and capital gains tax rates to differ. This is not surprising.

The Cash-Rich Firm

For the cash-rich firm things are not quite as simple. This happens because there is an

extra effect that was not previously present. We call this effect dividend capitalization.

At t = 1, the cash-rich firm pays corporate tax of �c�1. It invests IR dollars and

returns the rest of the cash balance of (1− �c) �1 − IR to the investor. This distribution

is taxed as a dividend because it comes from periodic earnings.

At t = 2 the firm pays out the earnings from the original and the new projects

(1− �c) [�1 + � (IR)] as a dividend. The firm then liquidates its capital (B + IR) and

returns it to the investor as a capital gain. The investor’s tax basis is B. Thus the

portion of the distribution subject to the capital gains taxation is ((B + IR)−B) = IR.

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The investor’s wealth at t = 2 is given by

VR =

⎡⎣ Bank Deposit︷ ︸︸ ︷(1− �d) [(1− �c)�1 − IR]︸ ︷︷ ︸

After tax t=1 dividend

+K

⎤⎦ [1 + r (1− �i)] + (1− �d) (1− �c) [�1 + � (IR)]︸ ︷︷ ︸After-tax t=2 dividend

+ B + IR − �gIR︸ ︷︷ ︸After-tax Cap-gains payout

.

The way the problem is set up ignores the possibility of the firm paying out cash and

simultaneously raising fresh cash at t = 1. This would only be optimal if the capital

gains tax rate were significantly higher than the dividend tax rate. To rule out this un-

usual possibility we assume that �g < (1 + r (1− �i)) �d.10 This assumption is empirically

natural given the current and historical personal tax rates in the United States.

The first order condition is given by

∂VR∂IR

= (1− �d) (1− �c) �′ (IR) + (1− �g)− (1 + r (1− �i)) (1− �d) = 0 (9)

Solving this condition provides the marginal pre-tax required rate of return given by,

�′ (IR) =r (1− �i)(1− �c)

− (�d − �g)(1− �d) (1− �c)

≡ �R. (10)

As before the key issue is the different investment incentives of the cash-poor firm and

the cash-rich firm. This difference is created by the difference in their marginal required

rate of return (�P − �R ≡ Δ�). Direct substitution gives,

Δ� =r(1− �i)�d

(1− �d)(1− �c)︸ ︷︷ ︸Dividend tax-overhang

+�d − �g

(1− �d)(1− �c)︸ ︷︷ ︸Dividend capitalization

. (11)

10Consider a firm that on the margin pays $1 of dividend and raise $1 of fresh equity at t = 1.The investor would be forced to realize a divided tax of �d, and the wealth at t = 2 will reduce by�d (1 + r (1− �i)). If instead the firm retains $1 and invests it at t = 1 and returned it as a capital gainat t = 2, the investor will pay �g as taxes at t = 2. Thus, when �g > (1 + r (1− �i)) �d, raising freshequity dominates investing retained earnings.

12

The required rate of return difference is positive as long as �g < �d[1 + r(1− �i)]. Not

coincidentally this is the same condition needed for reinvesting retained earnings to be

optimal for the cash-rich firm. Historically, the capital gains tax rate has been lower than

the dividend tax rate in the United States. Thus the lower required rate of return enjoyed

by the cash-rich firm exists under realistic tax parameters.

How should we think about (11)? The assumed structure of the tax code allows the

cash-rich firm to achieve two objectives when investing retaining earnings. First, the firm

defers the investor’s dividend tax liability to a later period. This tax-overhang effect is

the first item on the right hand side of (11). Second, the firm converts the t = 1 dividend

payout to a capital gains payout, which may be subject to a lower tax rate. This is the

second item on the right hand side of (11). In other words, by investing retained earnings

the firm is able to capitalize the dividend payment. That is why we call this effect the

dividend-capitalization effect.

With this richer specification of the tax code, there are two benefits for the cash-

rich firm’s investor relative to the cash-poor’s investor. The investor of the cash-rich firm

benefits from both the dividend-tax-overhang effect and the dividend-capitalization effect.

Accordingly, the required rate of return is lower for the cash-rich firm.

The next proposition compares the investment incentives of the cash-poor firm and

the cash-rich firm in a tax regime that allows for dividend capitalization.

Proposition 2 If it is optimal for the cash-rich firm to invest retained earnings (�g <

�d[1 + r(1− �i)]), then the cash-rich firm’s optimal level of investment is greater than that

of the cash-poor firm (I∗R > I∗P ). The cash-poor firm’s optimal investment is decreasing in

the dividend tax rate (∂I∗P∂�d

< 0). The cash-rich firm’s optimal investment is increasing in

the dividend tax rate (∂I∗R∂�d

> 0).

Proof: From (11) we have �R < �P when �g < �d[1 + r(1 − �i)]. I∗R > I∗P results from

�R < �P and the concavity of �(I).

13

The comparative statics of �P and �R with respect to �d are

∂�P∂�d

=r(1− �i)

(1− �d)2(1− �c)> 0;

∂�R∂�d

= − 1− �g(1− �d)2(1− �c)

< 0.

Combining these with equation (5) gives the result that∂I∗P∂�d

< 0 and∂I∗R∂�d

> 0. This

completes the proof.

The major difference between Proposition 2 and Proposition 1 is that once we allow for

dividend capitalization the cash-rich firm’s investment becomes increasing in the dividend

tax rate. This is because an increase in the dividend tax rate increases both the benefit

from deferring the dividend taxes (a larger dividend-tax-overhang effect) and the benefit

from converting dividends to capital gains (a larger dividend-capitalization effect). The

increased benefit more than offsets the increase in double taxation.11

The question of whether investors benefit from dividend capitalization is largely an

institutional and empirical question. Our analysis shows that if this effect is relevant,

then the cash-rich firm’s investment is increasing in the dividend tax rate (∂I∗R∂�d

> 0). If

it is not relevant, then the cash-rich firm’s investment is independent of the dividend tax

rate (∂I∗R∂�d

= 0). These are the predictions to be tested.

Finally, it is easy to see that in the absence of dividend taxation (�d = 0), the required

rate of return for the cash-poor firm is �P ∣�d=0 = r(1−�i)(1−�c) < �P ∣�d>0. This implies that

I∗P ∣�d>0 < I∗P ∣�d=0. The cash-poor firm underinvests in the presence of dividend taxation.

On the other hand, �R∣�d=0 = r(1−�i)+�g(1−�c) > �R∣�d>0, implying that I∗R∣�d>0 > I∗R∣�d=0. The

cash-rich firm overinvests in the presence of dividend taxation. The model implies that

a dividend tax cut will decrease both the under-investment by the cash-poor and the

11The result that the cash-rich firm’s required rate of return decreases with the dividend tax ratecan arise in other settings. For example Hennessy and Whited (2005) consider a dynamic model withendogenous investment and capital structure decisions. They also show that the marginal cost of capitalfor a cash-rich firm is decreasing in the dividend tax rate.

14

over-investment by the cash-rich. Empirical work that does not control for this type of

firm heterogeneity is likely to generate misleading results.12

II. Model Implications and Hypothesis Development

The implications to be empirically examined are comparative statics stated in the

propositions – how changes in dividend tax rates affect changes in corporate investment.

The model implies that a reduction in the dividend tax rate will lead to either no change

or a decrease in investment by cash-rich firms, and an increase in investment by the cash-

poor firms. To test the model implications it is natural to consider changes in the tax

code. Such quasi-natural experiments are attractive since changes in the tax code are

reasonably exogenous to the investment decisions of an individual firm.

Let Ii,t be firm-i’s investment in year t, �d,t be the dividend tax rate in year t, and

Δ be the first-difference operator. The model focuses on the implication of the firm’s

cash position for the dividend taxation effect. Thus we use CasℎPoori,t−1 to indicate

whether the firm is cash-poor or not at the beginning of year t. Let Xi,t denote a vector

of conventional firm-specific factors that may affect investment but are not in the model.

Finally, let �i,t be a regression error term.

Consider the following basic linear empirical model,

ΔIi,t = �Δ�d,t + �(CasℎPoori,t−1 ×Δ�d,t) + 1CasℎPoori,t−1 + 2ΔXi,t + �i,t. (12)

In this specification investment and the tax rates are both in the first-difference form,

but CasℎPoor is in the level form. This reflects the structure of the propositions being

tested—the effect of changes in dividend tax rates on changes in investment. According to

the analysis, this impact depends on whether the firm is cash-rich or cash-poor. Thus the

cash position is supposed to enter in the level form. Since the main variables of interest

are in the first-difference form, the other control variables are also in the first-difference

12In earlier drafts of this paper we analyzed a number of extensions including the use of debt financ-ing, and the impact of imperfect competition. These extensions generate fairly natural results that aredescribed in the empirical section. To save space the derivations are not presented.

15

form. The first-difference model has the added benefit of accounting for unobservable

factors that have a constant effect on a firm’s investment such as firm fixed effects or

industry fixed effects.13

The parameter � represents the effect of changes in dividend taxes on changes in the

cash-rich firm’s investment. The model (assuming dividend capitalization) predicts that

� > 0. That is, a dividend tax cut will lead to a decrease in the firm’s investment. If

there is no dividend capitalization, then in the model we can have � = 0.

The public finance literature has developed both an ‘old’ view (e.g., Poterba and

Summers (1984)) and a ‘new’ view (e.g., Auerbach and Hassett (2003)) of the impact of

dividend taxation on corporate investment. Under the old view double taxation is key, so

a dividend tax cut reduces the tax burden and stimulates investment. According to the

‘old’ view � < 0. Under the new view investment is financed out of retained earnings, and

a dividend tax cut has no effect on corporate investment. According to the ‘new’ view

� = 0. Therefore, the empirical framework allows us to test between the different views

about the dividend tax effect on a cash-rich firm’s investment incentives. The previous

literature is discussed in section IV.

For the cash-poor firm, the effect of dividend taxes on investment is given by (�+ �).

The model predicts that the effect is negative due to double taxation. That is, a dividend

tax cut will lead to an increase in the firm’s investment. Since � ≥ 0, the prediction is

that � < 0 and ∣�∣ > �. The ‘new’ view could be interpreted to mean that all firms are

cash-rich. If so, it contains no prediction for cash-poor firms. It could also be interpreted

to mean that � = 0. Similarly there is some ambiguity in how best to interpret the

implication of the ‘old’ view for �. It is possible to interpret the ‘old’ view to mean either

� < 0 or � = 0. In some sense one could think of the ‘old’ view as assuming that all firms

are like our cash-poor firms.

13In Wooldridge (2002) chapters 10.6 and 10.7 discuss in detail the advantages of using a first-differencemodel to address the fixed effect problem. It is worth stressing that the dividend tax change affects bothcash-poor firms and cash-rich firms. Cash-poor firms are not a control group for cash-rich firms. Thetheory has specific predictions about the reaction of each type of firms, not just the difference betweenthe two.

16

The parameter 1 gives the impact of being cash-poor on the change in investment.

This effect is not directly predicted by the model. But since the theory makes a predic-

tion on the interaction effect between cash-poorness and changes in the tax rates, it is

important to include the direct effect of cash-poorness to avoid a biased estimation of the

interaction effect.

According to the model cash-poor firms will have a lower level of investment than

cash-rich firms. But the empirical model does not regress the level of investment on the

level of cash-poorness. It explains the change in investment in terms of the level of cash-

poorness. Suppose that empirically the change in being cash-poor is correlated with the

level of being cash-poor. Then we would expect to find that 1 < 0. But it should be

stressed that this prediction, while seemingly reasonable, is not as tightly connected to

the theory as the other predictions.

III. Empirical Analysis

This section presents the empirical analysis. Section A describes the data and empirical

specification. Section B presents the main empirical results. Section C examines the

effectiveness of the identification strategy. Section D discusses robustness issues.

A. Data and Empirical Specification

A.1. Dividend Tax Rates

There are a number of alternative measures that have been used to proxy for the tax

rates. Graham (1996) provides a useful study. We use two popular measures. The main

measure for Δ�d is the yearly change in the U.S. federal average marginal dividend tax

rate from 1977 to 2006. This is the dollar weighted average marginal individual dividend

income tax as calculated by the NBER TAXISM model from micro data for a sample

of U.S. taxpayers.14 As a robustness check, we also use the time-series of the statutory

14See detailed information at http://www.nber.org/ taxsim/marginal-tax-rates/federal.html.

17

dividend tax rate from 1981 to 2006 from the OECD tax database.15 This tax rate is

computed as the net top statutory dividend income tax rate to be paid at the shareholder

level in the U.S., taking account of all types of reliefs and gross-up provisions at the

shareholder level.

Figure 1 plots the time series of the marginal dividend tax rate and that of the top

statutory dividend tax rate. The two time series are very similar to each other. It is

apparent from Figure 1 that in the following three periods the dividend tax rate underwent

a significant change: (i) in years 1982 and 1983 the marginal dividend tax rate decreased

by 7.6 percentage points, and the tax rate decreased by 5.5 percentage points in 1982

alone; (ii) from 1986 to 1988 there was another 7.4 percentage-point reduction; and (iii)

in 2003 there was a large 14.3 percentage-point reduction in the dividend tax rate in a

single year.

The focus on these three periods in the main analysis has two basic motivations. First,

small changes in the marginal dividend tax rates in the 1990s correspond to changes in

tax clienteles rather than real dividend tax changes. Second, if the theory has predictive

power, then the identification of the dividend tax effect must come from these relatively

large changes in the dividend tax rate. But we do check the robustness of the main results

in the entire period from 1977 to 2006.

Table 1 Panel A shows that the marginal dividend tax rate decreased from 34.4% to

12.3% as a result of the dividend tax cuts in the sample period. The median annual

change in the dividend tax rate is -2.9 percentage points.

A.2. Corporate Investment and Cash-Poorness

The firm level financial data is obtained from the COMPUSTAT industry annual

database. The empirical proxy for ΔI is the yearly change in a firm’s capital expenditure

ratio (COMPUSTAT item #128 divided by lagged item #6). Since the focus is on capital

expenditures, we exclude firms in the finance, insurance, and real estate sectors (2-digit

SIC code between 60 and 69). Also excluded are firms with the 2-digit SIC code equal to 90

15See detailed information at http://www.oecd.org.

18

or above because those firms are either non-private companies or shell holding companies

that have no real activities. Financial variables are truncated at the top and bottom 1%

of the distribution to reduce the influence of outliers. As shown in Table 1 Panel A, the

median investment ratio in the sample is 4.9 percentage points, and the median annual

change in the investment ratio is -0.3 percentage point.

For the variable CasℎPoor, the theory implies that it should be a state variable re-

flecting a firm’s financing margin. This variable should depend on not only a firm’s

cumulative cash balance, but also the firm’s optimal investment, which economists usu-

ally do not perfectly observe. To capture the cash-holding effect, our primary proxy for

CasℎPoor is one minus a firm’s cash-to-asset ratio (1−#1/#6). This measure is between

zero and one, and thus can serve as a probability measure. The higher the CasℎPoor

measure, the more likely that the firm is cash-poor and is on the equity-financing margin.

For robustness, we also compute three alternative measures of CasℎPoor. CasℎPoor2

is a dummy variable that equals one if a firm’s cash holding (item #1) is less than the

sum of its average level of capital expenditures (item #128) and the average level of

nonnegative non-cash working capital (max[0, item#4− item#1− item#5]) in the past

three years, and equals zero otherwise.16 The idea here is to use the firm’s average

investment spending in the recent past as a proxy for its optimal investment. This is

reasonable because corporate investment generally exhibits strong auto-correlation (see,

e.g., Eberly et al. (2008)).

CasℎPoor3 is a dummy variable that equals one if a firm’s cash holding is less than

the sum of its average level of long-term and short-term investment (as in CasℎPoor2)

and the average level of cash dividend payout (item #127) in the past three years, and

equals zero otherwise. CasℎPoor3 tells us whether a firm’s cash holding is sufficient to

cover its investment needs and regular dividend payout.

Bates et al. (2008) provide an empirical model for a firm’s need to hold cash (see

model (1) of Table 3 in their paper). In their model a firm’s need for holding cash

is positively related to its growth potential (measured by the ratio of market value of

16Positive non-cash working capital is like short-term investment that needs to be financed.

19

assets to book value of assets), investment (capital expenditures, R&D expenditures,

and acquisition cash flow), dividend practice (a dummy variable for common-dividend

payers), and industry cash flow risk (the average cash flow volatility in a two-digit SIC

code industry in the past ten years).17 Accordingly we compute the abnormal cash ratio

as the residual term from their regression model. CasℎPoor4 is defined as one minus the

abnormal cash ratio.

CasℎPoor3 and CasℎPoor4 take into consideration not only a firm’s investment need

for cash, but also a payout need for cash and a precautionary motive for holding cash.

Although our theory does not incorporate these other needs for cash, they may be empir-

ically important for the distinction between cash-rich firms and cash-poor firms.

Table 1 Panel A shows that the median cash-poorness is 0.94, which corresponds to a

median cash ratio of 6%. A little over three quarters of the firms are cash-poor according

to the definitions of CasℎPoor2 and CasℎPoor3. The median CasℎPoor4 is 1.004, which

corresponds to a median abnormal cash ratio of -0.4% based on the Bates et al. model.

Panel B shows that all four cash-poorness proxies are highly correlated with each other.

CasℎPoor has a correlation of 0.69 with CasℎPoor2, 0.70 with CasℎPoor3, and 0.79

with CasℎPoor4.

Table 1 Panel C compares the characteristics of cash-poor firms with those of cash-rich

firms. We assign the sample firms into one of three groups based on the tercile cutoffs

of the CasℎPoor4 distribution. For the purpose of this comparison, we call firms in the

top tercile “Cash-Poor” firms, and those in the bottom tercile “Cash-Rich” firms. Firm

size, investment, growth, leverage, dividend payout, and past external financing activities

between these two groups are compared. The average value of each variable for each group

and the Wilcoxon Z-statistics for the difference between the two groups are reported.

Empirically cash-rich firms are larger as indicated by the Wilcoxon Z-statistics, even

though their average asset sizes are smaller than those of cash-poor firms. Cash-rich firms

have higher growth potentials (measured by Q) but do not necessarily invest more in

capital expenditures. Cash-rich firms are also more likely to pay common dividend and

17Bates et al. (2008) also include cash flows from operations in the regression. This is not includedbecause this is related to the supply of cash, not the need for cash.

20

issue debt. Overall, the empirical characteristics of cash-rich firms and cash-poor firms

are consistent with the theoretical definitions of these two types of firms.

A.3. Control Variables

The ΔXi,t in equation (12) contains the first differences of prominent factors from

previous literature that influence investment. Specifically, following the findings in the

investment-Q-cash-flow literature, we control for the lagged change in a firm’s Tobin’s

Q (items [#6 − #60 + #25 × #199]/#6) and the lagged change in its EBITDA (item

#13/#6]). We also control for the lagged investment ΔIi,t−1. As discussed in Eberly

et al. (2008), lagged investment is empirically even more important than Q and cash flow.

Besides ΔXi,t, we also control for the direct effects of a firm’s cash-poorness so that we can

properly estimate the interaction effects of cash-poorness and tax changes. Table 1 Panel

B reports the pair-wise correlation between any two variables in the baseline regressions.

B. Results

B.1. Dividend Tax Effect on Investment

Table 2 presents results for the main empirical model in equation (12). Separate results

are reported for all the years with dividend tax cuts and for the years with the two largest

dividend tax cuts. The full dividend-tax-cut sample includes the three periods mentioned

before: from 1982 to 1983, from 1986 to 1988, and in 2003. The large tax-cut sample

includes the two large single-year dividend tax cuts in 1982 (-5.5%) and in 2003 (-14.3%).

Consider the direct effect of dividend taxation on capital expenditures. By the em-

pirical design this is the dividend tax effect on cash-rich firms’ investments. Assuming

dividend capitalization the model predicts that � > 0. If there is no dividend capitaliza-

tion, then we expect to find � = 0.

Table 2 shows that the coefficient estimate of Δ�d,t is positive and significant in all

models. In model (1) the estimated � is 0.215 and is significant at 1% confidence level.

21

This implies that a dividend tax cut (i.e., Δ�d,t < 0) leads to a decrease in investment

by cash-rich firms. Model (3) focused on the years of the two largest dividend tax cuts,

and the effect of dividend taxation on cash-rich firms’ investments becomes even stronger.

The estimate of � is 0.465 in those years, more than doubles the estimated effect in model

(1) where all the dividend tax cuts are included. This is as it should be if the empirical

identification strategy is correct.

A positive and significant estimate for � provides support for the existence of the

dividend-capitalization effect. Dividend taxation does affect the investment incentives of

cash-rich firms, but not in the way expected by policy makers. The empirical results

do not support the prediction from a pure tax-overhang effect that dividend taxes are

irrelevant to cash-rich firms’ marginal investment incentives.

The theoretical model predicts that the dividend tax effect on cash-poor firms’ invest-

ment is positive, which means that � should be sufficiently negative to outweigh the effect

of a positive �. This is exactly what we find in the data. The coefficient estimate of the

interaction term between the change in the dividend tax rate and a firm’s cash-poorness

is negative and statistically significant in all models. Models (1) and (3) show that the

estimates of � are larger in absolute magnitudes than the estimates of �. Accordingly

(�+�) is significantly below zero. These results imply that cash-poor firms and cash-rich

firms respond in opposite ways to dividend tax changes.

Now let us consider the economic significance of the dividend tax effect on both cash-

rich firms and cash-poor firms. To be concrete, consider model (3) and the 2003 dividend

tax cut (Δ�d = −0.143). The average firm in the sample has about $1 billion in assets.

First suppose that the average firm is a cash-poor firm in the top tercile of the CashPoor

distribution. The average cash-poorness in the top tercile is 0.99. Then the average

firm will increase its capital expenditures by $13.2 million (= (0.465 − 0.563 × 0.99) ×(−0.143)×$1 billion). Then suppose that the average firm is a cash-rich firm that has a

cash-poorness of 0.64, the average level in the bottom tercile of the CashPoor distribution.

Then the average firm will decrease its investment by about $15 million ( = (0.465−0.563×0.64)× (−0.143)×$1 billion).

22

The above calculations show that the distinction between a cash-poor firm and a cash-

rich firm is economically significant. Further, in our sample the average annual capital

expenditures of firms with about one billion dollars of assets is $73 million. Therefore, the

estimated changes in both types of firms’ capital expenditures due to the 2003 dividend

tax cut are also economically significant.

The heterogeneity in the dividend tax effect on cash-rich firms and cash-poor firms

implies that assessing the effect of a tax cut using changes in the average investment or

in the aggregate investment can be misleading. Following the 2003 dividend tax cut, the

average corporate investment increased by 0.7 percentage point or $7 million in a firm

with $1 billion in assets.18 This is much smaller than the estimated change in either the

cash-poor firm or the cash-rich firm. The effect of the dividend tax cut on the aggregate

investment depends on the distribution of cash-rich firms and cash-poor firms in the

economy. The estimated change in the aggregate investment in 2003 due to the dividend

tax cut is only 0.8% of the aggregate corporate assets, consistent with the flat investment

response documented in other studies.19

Significant dividend tax rate changes may be accompanied by other macroeconomic

events. For example, the 2003 dividend tax cut was only a part of the fiscal stimulus

policy—the Jobs and Growth Tax Relief Reconciliation Act. To control for the effects

of confounding events, year fixed effects are included in models (2) and (4). The direct

effect of a dividend tax change drops out because the change applies to all firms in a given

year. However, the rest of the results continue to hold. The negative estimate of � implies

that cash-poor firms tend to increase investment following a dividend tax cut. Even the

magnitude of the effect is similar to that in models (1) and (3) where we do not control

18To calculate the average effect we run the following regression: ΔIi,t = �Δ�d,t + ΔXi,t + �i,t inyears with large tax cuts (i.e., 1982 and 2003). That is, we do not distinguish between cash-rich firmsand cash-poor firms. The coefficient estimate of Δ�d is -0.052. Multiplying this coefficient estimate withΔ�d in 2003 (-0.143), gives the 0.7 percentage-point average tax effect on a firm’s investment.

19The aggregate effect is computed as follows. For each firm in year 2003 we compute the change in itsinvestment ratio due to the tax cut as 0.465×Δ�d,t − 0.563× (CasℎPoori,t−1 ×Δ�d,t), where t is 2003.The change in the level of investment is the change in investment ratio times the firm’s total book assetsat the beginning of year 2003. We then sum up the change in the investment level of all firms and divideit by the sum of the book assets of all firms, and this ratio is the estimated effect of the tax cut on theaggregate investment.

23

for the year fixed effects. This robustness test suggests that the results are unlikely to be

driven by general confounding events.

The direct effect of CashPoor is worth mentioning. The change in a firm’s investment

is negatively related to its cash-poorness. This implies that a cash-poor firm on average

decreases its capital expenditures. This result is consistent with the findings in the liter-

ature about the cash-sensitivity of investment. All the other control variables also have

effects consistent with the findings in the existing literature. Changes in firms’ invest-

ments are positively related to changes in Tobin’s Q and changes in operating cash flows.

Changes in investment are negatively related to lagged changes in investment, suggesting

that changes in investment are mean-reverting.20

In sum, the results in Table 2 suggest that a dividend tax cut stimulates investment

by cash-poor firms, but discourages investment by cash-rich firms. If cash-rich firms

dominate in the aggregate economy, then a tax cut like the one in 2003 can even lead to

a decrease in the aggregate investment. Presumably, this is not what was intended by

policy makers.

B.2. Evidence from New Business Formation

The theory implies that a dividend tax cut should lead to an increase in investment

by firms with little internal cash. An important example of cash-poor firms are potential

startups. Thus a key effect of a dividend tax cut should be to stimulate new business

formation.

Figure 2 Panel A illustrates the annual level of new business creation and the marginal

dividend tax rate between 1995 and 2005. The pattern is very clear: The number of new

firms created was largely unchanged from 1995 to 2002. Interestingly, the significant

dividend tax cut in 2003 was accompanied by a large surge in new business formation in

20In untabulated regressions we exclude the lagged change in investment. The results are similar tothose reported in Table 2. We also run separate regressions for firms with cash-poorness in the top tercileof the distribution and for those in the bottom tercile. This robustness test allows for different effects ofthe control variables for cash-poor firms and cash-rich firms. The results are similar to those reported inTable 2. The relationship between ΔI and Δ�d is positive for cash-rich firms and negative for cash-poorfirms.

24

2003 and in the following years. New business formation in the United States increased

by 7.5% in 2003 and the cumulative increase by the end of 2005 was 18%.21

Was the surge in new businesses due to other confounding changes in the macroeco-

nomic environment? Since there was little variation in new business creation during the

boom of the late 1990s and the bust of the early 2000s, the surge beginning in 2003 is

unlikely to be a pure business cycle effect. This observation is confirmed by Figure 2

Panel B. The time series of real GDP growth, interest rate (one year T-bill rate), and

the aggregate market-to-book ratio (the ratio of total market value of equity to total

book value of equity) all exhibited significant ups and downs from 1995 to 2002, yet new

business formation was flat.22

In sum, the casual evidence from the data of new business formation in the United

States is consistent with our findings about the behavior of cash-poor firms following

dividend tax cuts.

C. Testing Identifying Assumptions

This section focuses on the effectiveness of the empirical identification strategy. As

discussed already, changes in the dividend tax code are quasi-natural experiments that

affect all firms in the economy. Therefore the analysis is not subject to the selection bias

in a typical treatment effect model.

The key interest is the interaction between dividend tax changes and a firm’s cash

position. Thus our identification strategy relies on two main assumptions. First, we need

21Not all new businesses were organized as C-corporations that are subject to dividend taxation. How-ever, there is no reason to believe or any evidence that the fraction of C-corporations was systematicallydifferent in the time-series.

22The correlation matrix was calculated. The correlation between the number of new businesses andthe marginal dividend tax rate is -0.831 and is significant at 1% confidence level. The correlations betweenthe number of new businesses and the long-term capital gains tax rate and the corporate income tax rateare -0.592 and -0.209 respectively, and both are statistically insignificant. The correlations between thenumber of new businesses and real GDP growth, interest rate and aggregate market-to-book ratio are0.118, -0.10, and -0.271 respectively and are all statistically insignificant. The correlation matrix is notreported because there is only a fairly short time-series (11 years), which makes statistical inferences oflimited value.

25

it to be the case that Δ�d,t really captures the dividend taxation effect. There should

be no confounding events during the tax cuts that can explain the findings in our study.

Second, we need our CasℎPoor proxy to really capture the distinction between cash-rich

firms and cash-poor firms as analyzed in our theoretical model.

Accordingly the next task is to examine the validity of each of these assumptions.

C.1. Is It Really a Dividend Tax Effect?

So far the results have shown that changes in firms’ investments respond to changes

in dividend tax rates, and cash-rich firms and cash-poor firms respond differently as

predicted. One possible concern is whether the effects are really driven by dividend tax

changes. Perhaps the changes in dividend tax code simply pick up the effects of other

confounding macroeconomic factors.

Two findings established so far provide support for the identification strategy. First,

including year fixed effects does not change the interaction effect between dividend tax

changes and CashPoor. This implies that general confounding events are unlikely to drive

the results. Second, the dividend tax effects on both cash-poor firms and cash-rich firms

become stronger when the dividend tax changes are larger. This is as it should be if the

empirical identification strategy is correct.

Two more tests on this identifying assumption are carried out here. First, before the

2003 dividend tax cut, the variation in the U.S. dividend tax rate was highly correlated

with that in the wage income tax rate (correlation = 0.72). This means that changes in

the wage income tax rate is a potential confounding event. However, the theory suggests

that the cash-rich firm’s ability to defer investors’ personal income taxes does not apply

to wage income taxes. Thus the differential investment incentives of cash-rich firms and

cash-poor firms should disappear if we substitute changes in dividend taxes with changes

in wage income taxes. Accordingly Table 3 uses wage income taxes instead of dividend

taxes in models (1) and (2) of Table 2. The coefficient estimates of both the change in

the wage income tax rate and the interaction between the tax change and CashPoor have

26

the same signs as in Table 2 but are highly insignificant. Thus the dividend tax measure

is not merely proxying for wage income taxation effects.

Second, we know that some firms are less affected than others by tax changes due

to the tax status of their equity owners.23 In particular, dividend income distributed to

individuals through tax-exempt accounts should not be affected by tax changes. These

less-affected firms can serve as a noisy “control” group to help us control for the effects

of confounding macroeconomic events. If the identification strategy is effective, then the

dividend tax effect will be weaker in firms that are controlled by tax-exempt entities such

as pension funds, no matter whether the firms are cash-rich or cash-poor.

To implement this test we follow the approach in Chetty and Saez (2005). The Thom-

son financial institutional ownership database is used to identify types of institutions that

are not affected by tax changes – type 2 investors (insurance companies) and type 5 in-

vestors (including pension funds, nonprofit organizations, nonfinancial corporations, and

government agencies).24 Then at the beginning of each year, we compute Institution as

the total ownership by tax-exempt institutions in a firm. Next the sample firms are di-

vided into two groups. The Institution ≤ 10% (Institution> 10%) group consists of firms

with total ownership by tax-exempt institutions being no greater than (greater than) 10%.

10% is the cutoff for the top decile of the Institution distribution.25 The distribution of

cash-poorness is very similar across the two groups. The average cash-poorness is 0.85 in

both groups, and the standard deviation is around 20%.

Table 4 shows that in the years with large dividend tax cuts, the tax effects on corpo-

rate investment (i.e., � and � in the empirical model) are significant only in firms with

low ownership by tax-exempt institutions. The difference in the investment incentives

between cash-rich firms and cash-poor firms is also much larger in this group. Although

the difference between the Institution ≤ 10% group and the Institution> 10% group are

23Of course, a more complete theory would also allow for a choice of which investors hold equity inwhich firms. The development of such a theory, while clearly interesting, is far beyond the scope of thecurrent paper. In the empirical work we treat the ownership status as if it were exogenous. There is alot of investor heterogeneity and turnover for a vast number of motivations.

24As pointed out in Chetty and Saez (2005), after 1998 the Thomson financial database misclassifiesnew institutions which actually should belong to type 1-4 categories as type 5. Chetty and Saez hand-corrected the errors. We thank the authors for sharing their corrected data with us.

25We have also used a 5% cutoff and the results are similar but weaker.

27

not statistically significant, the economic difference is large. The direct dividend tax effect

(on cash-rich firms) in the Institution > 10% group is only 28% of that in the Institution

≤ 10% group (0.14 vs. 0.50). The interaction effect between tax changes and CashPoor

in the Institution > 10% group is only 30% of that in the Institution ≤ 10% group (-0.18

vs. -0.60).

C.2. Is It Really A Cash Position Effect?

In the theory the cash-poor firm and the cash-rich firm are firms on different financing

margins. Thus the cash position represents a firm type rather than just the amount

of cash holdings. A reasonable question to ask is whether the CasℎPoor proxies really

capture the distinction between the cash-poor firm and the cash-rich firm as described in

the theory.

Table 1 Panel C shows that firms with different cash-poorness are different in multiple

dimensions. In general, the differences are consistent with the theoretical distinction

between the two types of firms, which provides support for our empirical proxies for

CasℎPoor.

The theory suggests that changes in the dividend payout following a dividend tax

change can also shed light on this identification issue. In theory a cash-rich firm is on

the distribution margin and decides between retention for investment and distribution

of internal cash. Following a significant dividend tax cut, the cash-rich firm finds it

optimal to pay out cash and decrease investment on the margin. Thus the cash-rich firm

is expected to decrease its investment and at the same time increase its dividend payout.

A cash-poor firm is on the equity financing margin and decides whether to raise equity

and invest or to forgo the investment. A dividend tax cut makes it optimal for the firm to

increase investment. Therefore the cash-poor firm is not expected to increase its dividend

payout. The firm may not decrease its payout either, given all the costs associated with

dividend cuts in practice.

Table 5 examines the change in the dividend payout ratio following a dividend tax cut

for common-dividend-paying firms. Both models (1) and (2) show that the direct effect of

28

dividend tax changes on dividend payout is negative and significant, and the effect is bigger

in years with larger tax cuts. The interaction effect of dividend tax changes and CashPoor

is positive and significant. To see the economic meaning of these results, let us take model

(2) for an instance. Consider a cash-rich firm with CasℎPoor = 0.64, the average in the

bottom tercile of the CashPoor distribution. Model (2) implies that following the 2003

dividend tax cut this firm will increase its payout ratio by about 0.9 percentage point (=

(−0.153+0.145×0.64)×(−0.143)). Now consider a cash-poor firm with CasℎPoor = 0.99,

the average in the top tercile of the CashPoor distribution. This firm will only increase

its payout by about 0.1 percentage point (= (−0.153 + 0.145×0.99)× (−0.143)). In sum,

the evidence from dividend payout suggests that the empirically identified cash-poor and

cash-rich firms do behave in a manner consistent with the theory.

The last test on this identifying assumption is to make sure the CasℎPoor proxy does

not simply pick up the effects of some other firm characteristics such as firm size and

growth opportunities. To do so, we run the following set of regressions.

ΔIi,t = �1(Yi,t ×Δ�d,t) + �2Yi,t +BaseModel.

Yi,t is a firm characteristic listed in Table 1 Panel C except for investment. We include

them one by one in the regression, along with all the variables in the “BaseModel”,

model (1) in Table 2. The purpose of this exercise is to see whether any of those firm

characteristics subsumes the effect of CasℎPoor. They do not. After controlling for the

characteristics on which cash-poor firms and cash-rich firms are different, the interaction

effect between dividend tax changes and CasℎPoor is still negative and significant. More

over, most of the interaction effects between dividend taxes and those firm characteristics

have insignificant effects on corporate investment. The few variables whose interaction

with divided tax changes have marginal explanatory power for investment after controlling

for the CasℎPoor effect include EBITDA, leverage, and past debt issuance. To save

space we do not report these regression results.

29

C.3. Effect of Debt Financing

In theory the advantage of the cash-rich firm arises from a difference between internal

equity and external equity. The cash-rich firm and the cash-poor firm are in the same

position when it comes to debt financing. Thus the theory implies that the more debt

financing the cash-poor firm and the cash-rich firm can use, the smaller the difference in

their responses to dividend tax changes.26 If the empirical strategy correctly identifies the

advantage of the cash-rich firms, then we expect such advantage to be weaker in a group

of firms that can more easily raise debt for new investment.

The industry median leverage ratio is used as a proxy for the expected debt capacity

of a firm. At the beginning of a year, if a firm’s own leverage ratio is below the industry

median, then the firm on average has some debt capacity for new investment. This is

called a ‘High Debt Capacity’ firm. If a firm’s leverage ratio is above the industry median,

then the firm is on average more constrained to use debt financing for new investment.

This is called a ‘Low Debt Capacity’ firm.27 As expected, firms with low debt capacity

are on average more cash-poor. The average cash-poorness is 0.90 in the ‘Low Debt

Capacity’ group, and is 0.80 in the ‘High Debt Capacity’ group. The standard deviations

of CasℎPoor suggest that both groups contain cash-rich firms and cash-poor firms.

Table 6 provides evidence that debt capacity tends on mitigate the dividend tax effect

on the investment of both the cash-rich and the cash-poor firms. Both the direct dividend

tax effect and the interaction effect with CashPoor are much stronger in firms with low

debt capacity. The differences across the two groups are statistically significant. Let us

consider a cash-poor firms with CasℎPoor = 0.99 and a cash-rich firm with CasℎPoor =

0.64. If both these firms have low debt capacity, then following the 2003 dividend tax cut

the change in the cash-rich firm’s investment ratio is -0.8 percentage point (= (0.331 −0.431 × 0.64) × (−0.143)), and is 1.4 percentage points (= (0.331 − 0.431 × 0.99) ×

26In earlier versions of the paper we explicitly derived �P and �R assuming that a fraction of thenew investment can be financed by risk-free debt. We show that the advantage of the cash-rich firm ascaptured by Δ� is decreasing in the debt ratio of the new investment. The proof is available from theauthors upon request.

27In unreported regressions, we have also used a firm’s interest coverage ratio to identify the firm’sdebt capacity. The results are similar to those reported in Table 6.

30

(−0.143)) for the cash-poor firm. If both firms have high debt capacity, then the change

in investment would be -0.3 percentage point (= (0.14 − 0.181 × 0.64) × (−0.143)) for

the cash-rich firm and 0.6 percentage point (= (0.14 − 0.181 × 0.99) × (−0.143)) for the

cash-poor firm. Among firms with low debt capacity, the dividend tax effects on both

cash-rich firms and cash-poor firms are bigger in absolute values. The difference between

the reactions of these two types is also larger. These results suggest that the empirical

strategy does capture the advantage of cash-rich firms as implied by the theory.

Overall, the exercises in this section show that the identification strategy is effective.

The findings are driven by dividend tax changes rather than confounding events. The

CasℎPoor proxy seems to capture the distinction between cash-rich firms and cash-poor

firms. The results also seem to reflect effects that arise from a difference between inside

equity and outside equity and get mitigated in the presence of debt financing.

D. Robustness and Extension

D.1. Alternative Definitions of Cash-Poorness

As mentioned in Section III.A.2, besides the primary proxy for CasℎPoor we have

constructed three alternative proxies, all of which try to measure a firm’s cash-poorness

relative to its investment and other needs. Table 7 shows that the baseline results are

robust to using the alternative proxies for cash-poorness. In each panel of Table 7, the

estimate of � is positive and significant, and the estimate of � is negative and significant

and (�+�) is significantly below zero. The dividend tax effects become stronger in years

with larger dividend tax changes.

D.2. Longer-Horizon Investment Changes

The main empirical analysis examines the contemporaneous one-year change in the

corporate investment ratio. Table 8 examines the cumulative two-year changes in corpo-

rate investment ratios following a dividend tax change. The predicted effects of dividend

taxes on investment still hold. Consider model (2) in Table 8. Following a dividend tax cut

31

like the one in 2003, a cash-poor firm with a billion dollars of assets and CasℎPoor = 0.99

will increase investment by $37.5 million in two years. This almost triples the one-year

increase of $13 million estimated in Table 2.

D.3. Other Robustness Tests

The empirical analysis has focused on years with actual dividend tax changes because

those are the time periods during which we expect to see the dividend tax effect on

corporate investment. As a robustness check, we run the baseline model in Table 2 using

information from the entire sample period of 1977-2006. Since this includes many years

with no actual dividend tax changes, we expect the estimated dividend tax effects on

corporate investment to be much weaker. Table 9 shows that the estimates of � and �

for the full sample still have the predicted signs, but as expected, are much smaller in

magnitudes compared to the estimates in Table 2 in which only the years with tax changes

are included.

Not all firms in our sample pay dividends at the time when the dividend tax changes

happen. However, dividend taxes will still matter for the non-dividend-payers’ cost of

capital as long as the firms will start to pay dividends at some point in the future.

As a robustness test, we restrict our sample firms to be dividend payers. A firm is

a dividend payer if it has paid dividend before the dividend tax change or it initiates

dividend payment within two years after the tax change. Table 9 shows that the results

are robust to this sample restriction.

D.4. Extension: Effect of Competition

In reality firms with different or similar cash positions compete with each other in

the product market. How does competition affect the heterogeneous responses of firms to

dividend tax changes?28

28In earlier versions of the paper we explicitly derived an industry equilibrium with Cournot Compe-tition to show the effect of competition on how firms responde to dividend tax changes. Detailed proofsare available from the authors upon request.

32

First consider a cash-poor firm and a cash-rich firm in the competition. Following a

dividend tax cut, the cash-poor firm would like to increase its investment, while the cash-

rich firm would like to decrease its investment. In an industry equilibrium, the contraction

of the rival cash-rich firm makes it attractive for the cash-poor firm to expand even further.

Thus competition would amplify the dividend tax effect on a firm’s investment if the firm

and its rival firm are in different cash positions.

Now consider two cash-poor firms in the competition. Following a dividend tax cut,

both firms want to increase their investment. Due to competition they will constrain each

other’s ability to expand. Thus competition would dampen the effect of the tax change if

the firms are in the same cash position. The same intuition applies to the case in which

two cash-rich firms compete.

In sum, in an industry in which there are both cash-poor and cash-rich firms, both

types of firms’ investments tend to respond more dramatically to the dividend tax changes,

but in opposite directions. In an industry in which there are only (or mostly) cash-poor

firms or cash-rich firms, each firm’s response is dampened.

To capture the degree of similarity between firm-i’s cash position and its rival firms’

positions, we compute the standard deviation of firms’ cash-poorness within a 4-digit SIC

code industry at the beginning of each year. A low (high) standard deviation means

that firms in the industry tend to have similar (different) cash positions. Then we assign

firm-i into the group of Similar Cash Positions if its industry standard deviation of cash-

poorness is in the bottom tercile of the distribution in that year. We assign firm-i into

the group of Different Cash Positions if its industry standard deviation of cash-poorness

is in the top tercile of the distribution in that year.

The average cash-poorness in the Similar group is 0.94 with a standard deviation of

8%. This implies that most of the firms in this group are cash-poor firms. The average

cash-poorness in the Different group is about 0.74 with a standard deviation of 26%. This

implies that this group contains both cash-rich firms and cash-poor firms.

Table 10 model (1) shows that following a large tax cut the average dividend tax effect

on investment is -0.135 in the Different group, implying that on average a large tax cut

33

stimulates corporate investment. This average effect more than doubles the effect in the

Similar group in model (3) (-0.06). Models (2) and (4) distinguish between cash-rich firms

and cash-poor firms. In the Different group, the marginal effect of a dividend tax cut

on a cash-rich firm with CasℎPoor = 0.64 is a 8 percentage-point decrease in investment

(= 0.949 × 0.64 − 0.689), and a 25 percentage-point increase in investment for a cash-

poor firm with CasℎPoor = 0.99. The distinction between cash-rich firms and cash-poor

firms largely disappears in the Similar group, since most of the firms in this group are

cash-poor.29

IV. Previous Literature

The literature contains a number of distinct theories for how taxes affect corporate

decision-making.30 A natural conceptual benchmark is the idea that taxes and tax changes

have no effect. This can happen in a world with rational decision making (Miller and

Scholes, 1978) when the marginal investor is part of a tax-exempt clientele. At the other

extreme, this could also happen in a behavioral setting. If taxes are not salient then they

will have a negligible effect on decisions (‘out of sight, out of mind’).

The strict idea of dividend tax irrelevance seems to be fairly clearly rejected by various

studies. For example, Chetty and Saez (2005) find that firms increased dividend payout

after the 2003 dividend tax cut. Our study also shows empirically that dividend taxes

have important effects on corporate investment.

When going beyond the idea of tax irrelevance, there is a traditional or ‘old view’

from the public finance literature. According to the old view, dividend taxes reduce

the investor’s return to investing. Accordingly savings is reduced. A dividend tax cut

reverses this, inducing people to increase their savings. This in turn allows an increase in

corporate investment, corporate profits, and (over the long run) in dividend distributions.

The implicit assumption is that retained earnings are not an important marginal source

29In unreported regressions, we also do the same exercise using all the years with dividend tax cuts.The difference between the Similar group and the Different group still exists but is smaller in magnitude.

30The literature on taxes and corporate finance is large. For a valuable review see Graham (2003).

34

of funds. Supportive time series evidence has been provided by Poterba and Summers

(1984) and Poterba and Summers (1985) using UK data, and by Poterba (2004) using US

data. Direct evidence that dividend taxes are capitalized into asset prices is provided by

Klein (2001) and Sialm (forthcoming).

In contrast, the ‘new view’ (1970s vintage) assumes that the marginal source of fi-

nance for new investment is retained earnings, not new equity issuance. In this case, the

tax advantage of retaining earnings precisely offsets the double taxation of subsequent

dividends: dividend taxes have no impact on the investment incentives of firms. Propo-

nents of the new view argue that a dividend tax cut is irrelevant for corporate decisions.

It results in a pure transfer of resources from the government to the investor/taxpayer.

Models of the new view include King (1974) and Auerbach (1979).31

Evidence for the new view often takes the form of the statistically insignificant empiri-

cal relationship between corporate investment and dividend taxation (Desai and Goolsbee,

2004). But as Auerbach and Hassett (2003) pointed out, empirical research testing the

new view implications should take the firm’s source of funds more seriously. They show

that there is significant heterogeneity in the marginal source of funds in a sample of

US firms. Their study is generally interpreted as indicating that retained earnings is an

important source of financing for corporate investment.

When compared to the previous studies, the cross-sectional heterogeneity in firms’ cash

positions is front and center in our analysis. The cash positions provide a good indication

of firms’ marginal sources of funds. Our study shows that when firms’ cash positions

are properly taken in account, dividend taxation has a first order effect on corporate

investment. This is very different from the approach taken by Desai and Goolsbee (2004)

31When assuming no dividend capitalization, our model also implies that the cash-rich firm’s marginalinvestment incentive is independent of the dividend tax rate. However, the economic intuition is com-pletely different from that of the new view. The new view assumes that the capital gains taxes are paidupon accrual. This means that if the new project increases the value of the firm at time 1, the investorimmediately pays capital gains taxes on the value increase. Therefore, although the retained earningspostpones the investor’s dividend tax liability, it at the same time increases the investor’s capital gainstax liability. In a perfectly competitive equilibrium with risk-neutral investors and perpetual projects,the two forces exactly offset each other. We assume that the capital gains taxes are paid upon realiza-tion, which is realistic. Also, our results do not rely on any particular assumptions about the nature ofcompetition.

35

who do not investigate the cross-sectional differences in firms’ cash positions, and find

little or no effect of the 2003 dividend tax cut on corporate investment.

Korinek and Stiglitz (2009) study the impact of personal dividend taxation on invest-

ment in a model that allows for cross-sectional differences but has no corporate level taxes

or other non-dividend forms of personal level taxation. They assume that due to capital

market imperfections the firm cannot instantly raise funds to take the project (if one

arrives), and so the firm may hold cash. Holding cash within the firm is more expensive

than holding cash outside the firm, due to agency costs or managerial myopia. In common

with our analysis they distinguish firms that can self-finance from those that cannot do so.

They study the impact of various dividend tax changes on tax arbitrage strategies by the

firm. Since they only consider dividend taxation they do not offer an analysis like ours,

of how various taxes simultaneously affect firm decisions. They provide a simulation of

the model, but no empirical testing is done. In contrast, we present empirical test results

rather than simulations of our model.

Several studies in the corporate finance literature have examined the implications

of personal taxes on equity for firms’ capital structure decisions. Green and Hollifield

(2003) provide an interesting analysis of the relative advantages of equity over debt at the

level of personal taxes in a dynamic model in which firm payout takes the form of share

repurchases. They show that the advantage of equity largely comes from the option to

defer capital gains by investors who optimally choose the timing to tender their shares.

The value of this option may be quantitatively important for firms’ capital structure

decisions. In contrast to Green and Hollifield (2003), we examine the firm’s option to

defer investors’ personal taxes via investing retained earnings, and its implication for

corporate investment.

Hennessy and Whited (2005) consider a dynamic model in which the firm optimally

chooses capital structure, investment, and payout. They argue that the firm’s financing

margin is important in determining its optimal leverage. A related point is made by

Lewellen and Lewellen (2006). They argue that the tax advantage of internal equity

over external equity implies that the optimal leverage is a function of internal cash flows.

36

Both studies, along with Green and Hollifield (2003), show that cash-rich firms have less

incentive to use debt finance than the static trade-off theory has implied.

The prior literature thus contains a number of papers that recognize the important

distinction between investment that is financed out of retained earnings, and investment

that is finance with newly raised funds. However, the mechanism by which dividend taxes

affect corporate investment incentives has not been synthesized in our manner previously.

Accordingly the previous empirical studies of the dividend tax effect on investment have

examined hypotheses in a way that resulted in a serious misinterpretation of the evidence.

By contrasting cash-rich and cash-poor firms we have been able to identify the empirically

important role of dividend taxation.

V. Conclusion

Dividend taxation has a significant impact on corporate investment. It affects cash-

rich and cash-poor firms in different ways. Dividend taxation tends to induce cash-rich

firms to over-invest and cash-poor firms to under-invest. A dividend tax cut reduces both

distortions, causing cash-rich firms to reduce investment, and cash-poor firms to increase

investment.

The impact of the dividend tax rate changes from 1977 to 2006 is studied empirically.

The predicted effects are observed. These effects are not limited to just the case of the

2003 tax changes. They apply more broadly.

Significant attention is paid to whether we have correctly identified the source of

changes in investment. Thus other potentially confounding changes in the tax code are

studied. Year fixed effects are used to control for potentially omitted macroeconomic

factors. Since the main empirical specification is in first differences, firm-specific time-

invariant factors are already taken into account. Going further, firms with substantial

tax-exempt institutional ownership are compared to those with little of such ownership.

The effects of debt finance and product market competition are also examined. Finally,

37

robustness to alternative definitions of firm cash-richness and longer time horizon effects

are studied. In each case, the predicted effects are observed.

We all know that we must pay taxes, and that taxes take a nontrivial amount of

money. Corporate treasurers ought to worry about the impact of personal taxes on their

investors. So the fact that dividend taxation affects corporate investment is, in a sense,

reassuring for corporate finance.

On the other hand, the dominant MBA corporate finance textbooks consider dividend

taxes when only discussing dividends. They ignore dividend taxes when teaching students

how to calculate the weighted average cost of capital. For instance, consider the derivation

of the WACC in Ross, Westerfield and Jaffe (2008, chapter 15) or the essentially similar

derivation in Brealey, Myers and Allen (2008, chapter 19). Both include a corporate tax

rate, and neither include any other tax terms in the formulas that are taught. High quality

practitioner accounts provide similar advice. For example, consider Koller, Goedhart and

Wessels (2005, pages 111 and 176). Thus a corporate manager following high quality

conventional advice, would likely include corporate taxes, but ignore personal taxes when

making investment decisions. Thus the evidence that corporate investment is actually

affected by dividend taxation makes an interesting contrast.

Further evidence on our approach ought to emerge in the next few years. In 2010 the

Bush tax cuts are set to expire. Our study suggests that the impact will be particularly

hard on cash-poor firms and start-up firms.

38

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Table 1: Summary Statistics The summary statistics are reported for firm-year observations with non-missing IΔ . The sample period includes years with dividend tax changes between 1977 and 2006. Firms in the finance and real estate sectors (SIC code 6000-6999) are excluded. I is the capital expenditures ratio (COMPUSTAT item #128 divided by lagged item #6). dτ is the NBER marginal dividend tax rate. Q is the Tobin’s Q (items [#6− #60 + #25 × #199] / #6). EBITDA is the cash flow before interest, tax and depreciation (items [#13/#6]). Div is the common dividend payout ratio (items [#21 / #6]). Δ indicates the time-series first difference of a variable. CashPoor is one minus the cash ratio (items [#1 / #6]). CashPoor2 is a dummy variable that equals one if a firm’s cash holding (item #1) is less than the sum of its average level of capital expenditures (item #128) and the average level of nonnegative non-cash working capital (items [#4 − #1 − #5]) in the past three years, and equals zero otherwise. CashPoor3 is a dummy variable that equals one if a firm’s cash holding is less than the sum of its average level of capital expenditures and the average level of nonnegative non-cash working capital and the average level of cash dividend payout (item #127) in the past three years, and equals zero otherwise. CashPoor4 is one minus the abnormal cash ratio, which is the actual cash ratio minus the predicted value obtained by regressing cash ratio on industry cash flow risk, inflation-adjusted firm size, Q, net working capital, leverage, dividend-paying dummy, capital expenditures, R&D expenditures, acquisition cash flow (see Table 3 model 1 of Bates et al. 2008). Institution is the total percentage equity ownership by tax-exempt institutions. Leverage is book value of debt over book value of assets (items [#9 + #34]/ #6).

Panel A # of Obs. Mean Median Minimum Maximum

dτ 33198 0.262 0.277 0.123 0.344 I 33198 0.068 0.049 0.000 0.465 Q 28220 1.888 1.313 0.542 10.000 EBITDA 32690 0.041 0.106 -2.847 0.443 Div 32887 0.009 0.000 0.000 0.142

dτΔ 33198 -0.052 -0.029 -0.143 -0.022 IΔ 33198 -0.008 -0.003 -0.282 0.241 QΔ 24502 -0.145 0.020 -9.642 8.042 EBITDAΔ 29738 -0.009 -0.005 -1.184 1.158

ΔDiv 32738 -0.000 0.000 -0.134 0.134 CashPoor 32940 0.862 0.939 0.092 1.000 CashPoor2 27474 0.763 1.000 0.000 1.000 CashPoor3 27474 0.776 1.000 0.000 1.000 CashPoor4 20506 0.982 1.004 0.160 1.801 Institution 33198 0.027 0.000 0.000 1.000 Leverage 33104 0.284 0.254 0.000 0.900

42

(Table 1 continued)

Panel B: Correlation Tables

This panel reports the pair-wise correlation between variables in our baseline regressions. ** indicates significance at 1% level.

tIΔ td ,τΔ 1−tCashPoor 1−Δ tQ 1−Δ tEBITDA 1−Δ tI

tIΔ 1.00

td ,τΔ -0.02** 1.00

1−tCashPoor -0.07** 0.12** 1.00

1−Δ tQ 0.07** 0.12** 0.10** 1.00

1−Δ tEBITDA 0.10** -0.04** 0.00 -0.01 1.00

1−Δ tI -0.25** 0.01 0.02** 0.03** -0.05** 1.00

CashPoor CashPoor2 CashPoor3 CashPoor4 CashPoor 1.00 CashPoor2 0.69** 1.00 CashPoor3 0.70** 0.97** 1.00 CashPoor4 0.79** 0.49** 0.51** 1.00

46

(Table 1 continued)

Panel C: Cash-Poor Firms and Cash-Rich Firms In this panel we report and compare the characteristics of cash-poor firms and cash-rich firms. “Cash-Poor” means that CashPoor4 is in the top tercile of the distribution. “Cash-Rich” means that CashPoor4 is in the bottom tercile of the distribution. Assets is the value of book assets (item #6). Sales is net sales (item #12). MVE is the market value of equity. Dividend Payer is a dummy variable that equals one if a firm pays common dividend in a given year. Past Equity Issuance is the fraction of years with a significant net equity issuance (net issuance amount exceeding 5% of assets) in the past five years. Past Debt Issuance is the fraction of years with a significant net debt issuance (net issuance amount exceeding 5% of assets) in the past five years. We report the average value of each variable. The last column reports the Wilcoxon Z-statistics for the difference between the two groups. For each variable, a negative Z-statistic means that the cash-poor firms tend to have a smaller value than the cash-rich firms. ** indicates significance at 1% level.

Cash-Poor Cash-Rich Wilcoxon Z for Difference

Assets 949 726 -16.99** Sales 866 708 -4.00** MVE 1174 769 -25.63** Q 2.049 2.191 -13.62** I 0.064 0.061 5.80 EBITDA 0.003 0.035 -11.10** Sales Growth 0.200 0.179 -0.183 Leverage 0.243 0.226 38.04** Div 0.007 0.007 -8.66** Dividend Payer 0.247 0.293 -14.09** Past Equity Issuance 0.162 0.156 0.10 Past Debt Issuance 0.147 0.165 -3.61**

47

Table 2: Corporate Cash Holding and Dividend Tax Effect on Investment The dependent variable is , the yearly change in a firm’s capital expenditures ratio. “All Tax Changes” include years 1982, 1983, 1986, 1987, 1988, and 2003. “Large Tax Changes” include the two largest dividend tax cuts in 1982 (-5.5%) and in 2003 (-14.3%). Robust standard errors clustered by firm are reported in brackets. ** indicates significance at 1% levels.

tIΔ

All Tax Changes Large Tax Changes

Predicted Sign (1) (2) (3) (4)

td ,τΔ + 0.215** 0.465** [0.025] [0.086]

1, −×Δ ttd CashPoorτ − -0.287** -0.268** -0.563** -0.563** [0.029] [0.029] [0.094] [0.094]

1−tCashPoor -0.048** -0.046** -0.086** -0.086** [0.003] [0.003] [0.013] [0.013]

1−Δ tQ 0.005** 0.005** 0.004** 0.004** [0.001] [0.001] [0.001] [0.001]

1−Δ tEBITDA 0.036** 0.034** 0.021** 0.021** [0.003] [0.003] [0.003] [0.003]

1−Δ tI -0.220** -0.222** -0.225** -0.225** [0.010] [0.010] [0.018] [0.018] Constant 0.031** 0.019** 0.065** -0.001 [0.003] [0.002] [0.012] [0.002] Year Fixed Effects included included Observations 23572 23572 8326 8326 Adjusted R-squared 0.09 0.09 0.09 0.09

48

Table 3: Personal Wage Income Tax and Corporate Investment The dependent variable is , the yearly change in a firm’s capital expenditures ratio. The sample period includes all the years with real dividend tax changes.

tIΔ

tw,τΔ is the percentage-point change in the personal wage income tax rate. Robust standard errors clustered by firm are reported in brackets. ** indicates significance at 1% level.

(1) (2) tw,τΔ 0.035

[0.265] 1, −×Δ ttw CashPoorτ -0.156 -0.201

[0.295] [0.295] 1−tCashPoor -0.031** -0.030**

[0.005] [0.005] 1−Δ tQ 0.005** 0.005**

[0.000] [0.000] 1−Δ tEBITDA 0.036** 0.034**

[0.003] [0.003] 1−Δ tI -0.219** -0.221**

[0.010] [0.010] Constant 0.017** 0.014**

[0.005] [0.002] Year Fixed Effects Included Observations 23572 23572 Adjusted R-squared 0.06 0.06

49

Table 4: Tax-Exempt Institutional Shareholders and Dividend Tax Effect The sample period includes years with the two largest dividend tax cuts (in 1982 and 2003). The dependent variable is tIΔ . “Institution” is the total ownership of tax-exempt institutions at the beginning of year t. 10% is the cutoff for the top decile of the “Institution” distribution. The tax-exempt institutions include insurance companies (type 2 investors classified by Thomson Financial) and those classified as “others” by Thomson (type 5) whose names indicate that they are a pension fund, nonprofit institution, government agency or non-financial corporations. After 1998, Thomson Financial misclassifies new institutions which should belong to types 1-4 as type 5. We thus use the hand-corrected data from Chetty and Saez (2004). Chi-squared test results for the difference in the coefficient estimates in the two groups are reported in the last column. The last two rows in the table reports the summary statistics of CashPoor in each group. ** and * indicate significance at 1% and 5% levels, respectively.

Institution≤10% Institution>10% Chi-squared test for the difference

td ,τΔ 0.501** 0.140 1.63 [0.089] [0.269]

1, −×Δ ttd CashPoorτ -0.603** -0.179 1.94 [0.098] [0.289]

1−tCashPoor -0.090** -0.034 [0.014] [0.041]

1−Δ tQ 0.004** 0.003** [0.001] [0.001]

1−Δ tEBITDA 0.020** 0.026* [0.003] [0.010]

1−Δ tI -0.239** -0.084* [0.020] [0.037] Constant 0.069** 0.023 [0.012] [0.038] Observations 6812 1514 Adjusted R-squared 0.10 0.03 CashPoor (mean/median) 0.848/0.935 0.848/0.931 CashPoor (Std. Dev.) 0.199 0.192

50

Table 5: Evidence from Dividend Payout The dependent variable is , the yearly change in the common dividend payout ratio. Only firms that pay common dividends are included. Robust standard errors clustered by firm are reported in brackets. ** indicates significance at 1% level.

tDivΔ

(1) (2) All Tax

Changes Large Tax Changes

td ,τΔ -0.095** -0.153** [0.032] [0.048]

1, −×Δ ttd CashPoorτ 0.088** 0.145** [0.034] [0.051]

1−tCashPoor -0.002 0.004 [0.002] [0.005]

1−Δ tQ -0.001 0.001 [0.001] [0.001]

1−Δ tEBITDA 0.022** 0.032** [0.003] [0.006]

1−Δ tI -0.004 -0.002 [0.002] [0.004] Constant 0.002 -0.005 [0.002] [0.004] Observations 10172 3193 Adjusted R-squared 0.02 0.09

51

Table 6: Debt Capacity and Dividend Tax Effect The dependent variable is , the yearly change in a firm’s capital expenditures ratio. The sample period includes years with real dividend tax changes. A firm has “Low Debt Capacity” if it is book leverage ratio at the beginning of year t is above the industry median level. A firm has “High Debt Capacity” if it is book leverage ratio at the beginning of year t is below the industry median level. Robust standard errors clustered by firm are reported in brackets. Chi-squared test results for the difference in the coefficient estimates in the two groups are reported in the last column. The last two rows in the table reports the summary statistics of CashPoor in each group. ** indicates significance at 1% level.

tIΔ

Low Debt Capacity

High Debt Capacity

Chi-squared test for the difference

td ,τΔ 0.331** 0.140** 9.30** [0.055] [0.029]

1, −×Δ ttd CashPoorτ -0.431** -0.181** 12.95** [0.060] [0.035]

1−tCashPoor -0.060** -0.032** [0.007] [0.004]

1−Δ tQ 0.006** 0.004** [0.001] [0.001]

1−Δ tEBITDA 0.038** 0.033** [0.004] [0.004]

1−Δ tI -0.218** -0.229** [0.013] [0.015] Constant 0.039** 0.022** [0.006] [0.003] Observations 11778 11794 Adjusted R-squared 0.09 0.08 CashPoor (mean/median) 0.90/0.96 0.80/0.89 CashPoor (Std. Dev.) 0.15 0.22

52

Table 7: Alternative Definitions of Cash-Poorness The dependent variable is , the yearly change in a firm’s capital expenditures ratio. Panels A-C uses three alternative definitions of cash-poorness.

tIΔ

1, −Δ tiX includes the lagged change in Tobin’s Q, the lagged change in EBITDA, and the lagged change in investment. Robust standard errors clustered by firm are reported in brackets. **, *, and + indicate significance at 1%, 5%, and 10% levels, respectively.

Panel A All Tax Changes Large Tax Changes Predicted

Sign (1) (2) (3) (4)

td ,τΔ + 0.031** 0.077* [0.011] [0.032]

1, 2 −×Δ ttd CashPoorτ − -0.071** -0.063** -0.124** -0.124** [0.013] [0.013] [0.034] [0.034]

12 −tCashPoor -0.014** -0.014** -0.022** -0.022** [0.001] [0.001] [0.005] [0.005] Constant 0.002 -0.000 0.008 -0.003** [0.001] [0.001] [0.004] [0.001]

1−Δ tX included included included included Year Fixed Effects included included Observations 22462 22462 8150 8150 Adjusted R-squared 0.09 0.09 0.09 0.09

Panel B

All Tax Changes Large Tax Changes Predicted

Sign (1) (2) (3) (4)

td ,τΔ + 0.033** 0.090** [0.011] [0.034]

1, 3 −×Δ ttd CashPoorτ − -0.074** -0.066** -0.139** -0.139** [0.013] [0.013] [0.036] [0.036]

13 −tCashPoor -0.015** -0.014** -0.023** -0.023** [0.001] [0.001] [0.005] [0.005] Constant 0.002 -0.000 0.010* -0.003** [0.001] [0.001] [0.005] [0.001]

1−Δ tX included included included included

Year Fixed Effects included included Observations 22462 22462 8150 8150 Adjusted R-squared 0.09 0.09 0.09 0.09

53

(Table 7 continued) Panel C

All Tax Changes Large Tax Changes Predicted

Sign (1) (2) (3) (4)

td ,τΔ + 0.174** 0.238+ [0.042] [0.126]

1, 4 −×Δ ttd CashPoorτ − -0.215** -0.221** -0.302* -0.302* [0.041] [0.042] [0.129] [0.129]

14 −tCashPoor -0.033** -0.034** -0.045* -0.045* [0.004] [0.004] [0.018] [0.018] Constant 0.022** 0.014** 0.030 -0.004 [0.004] [0.004] [0.017] [0.003]

1−Δ tX included included included included Year Fixed Effects included included Observations 19814 19814 7061 7061 Adjusted R-squared 0.09 0.09 0.09 0.09

54

Table 8: Longer-Horizon Investment Changes The dependent variable, 1111 −+++ −=Δ+Δ=Δ ttttt IIIII , is the total change in investment rate in year t and year t+1. The cash-poorness variable is measured at the beginning of year t. Robust standard errors clustered by firm are reported in brackets. ** indicates significance at 1% level.

All Tax Reforms (1)

Large Tax Reforms (2)

td ,τΔ 0.141** 0.405** [0.031] [0.094]

1, −×Δ ttd CashPoorτ -0.236** -0.674** [0.036] [0.103]

1−tCashPoor -0.046** -0.103** [0.004] [0.014]

1−Δ tQ 0.006** 0.006** [0.001] [0.001]

1−Δ tEBITDA 0.033** 0.024** [0.003] [0.004]

1−Δ tI -0.307** -0.345** [0.012] [0.022] Constant 0.026** 0.061** [0.004] [0.013] Observations 21669 7773 Adjusted R-squared 0.10 0.16

55

Table 9: Other Robustness Tests The dependent variable is , the yearly change in a firm’s capital expenditures ratio. The first test includes all the years between 1977 and 2006, in many of which there was no dividend tax change. In the second test, a firm is a dividend payer if it has paid dividend prior to a given dividend tax change or it initiates dividend payment within two years after the tax change. Robust standard errors clustered by firm are reported in brackets. ** and * indicate significance at 1% and 5% levels, respectively.

tIΔ

Predicted Sign

Full Sample Period: 1977-2006

Dividend Payers Only, Years with Tax Change Only

td ,τΔ + 0.078** 0.169** [0.013] [0.040]

1, −×Δ ttd CashPoorτ − -0.030* -0.071** -0.208** -0.187** [0.015] [0.016] [0.043] [0.043]

1−tCashPoor -0.021** -0.021** -0.044** -0.042** [0.001] [0.001] [0.004] [0.004]

1−Δ tQ 0.004** 0.003** 0.008** 0.009** [0.0002] [0.0002] [0.001] [0.001]

1−Δ tEBITDA 0.032** 0.030** 0.052** 0.047** [0.001] [0.001] [0.007] [0.007]

1−Δ tI -0.224** -0.228** -0.232** -0.234** [0.005] [0.005] [0.013] [0.013]

Constant 0.015** 0.025** 0.031** 0.027** [0.001] [0.001] [0.004] [0.003]

Year Fixed Effects Included Included Observations 121191 121191 14307 14307

Adjusted R-squared 0.08 0.09 0.10 0.10

56

Table 10 Competition and Dividend Tax Effect on Investment The dependent variable is , the yearly change in a firm’s capital expenditures ratio The Similar Cash Positions group includes industries whose within-industry standard deviation of firms’ cash-poorness is low (in the bottom tercile of the sample distribution). The Different Cash Positions group includes industries whose within-industry standard deviation of cash-poorness is high (in the top tercile of the sample distribution). The sample period includes years with large dividend tax changes. Robust standard errors clustered by firm are reported in brackets.

tIΔ

1, −Δ tiX includes the lagged change in Tobin’s Q, the lagged change in EBITDA, and the lagged change in investment. **, * and + indicate significance at 1%, 5%, and 10% levels. We also report firm-level average and median cash ratio and the standard deviation of cash ratio in each group.

Large Tax Reforms

Different Cash Positions (cash-rich & cash-poor)

Similar Cash Positions (mostly cash-poor)

(1) (2) (3) (4) td ,τΔ -0.135** 0.689** -0.060** 0.312

[0.033] [0.165] [0.016] [0.204] 1, −×Δ ttd CashPoorτ -0.949** -0.395+

[0.190] [0.216] 1−tCashPoor -0.136** -0.068*

[0.027] [0.027] Constant -0.024** 0.094** -0.013** 0.051* [0.004] [0.023] [0.002] [0.025]

1, −Δ tiX Included Included Included Included Observations 2833 2788 2991 2987 Adjusted R-squared 0.09 0.12 0.13 0.13 CashPoor (mean/median) 0.74/0.82 0.94/0.97 CashPoor (std. dev.) 0.26 0.08

57

Figure 1: U.S. Dividend Tax Rate

0 . 0 0

5 . 0 0

1 0 . 0 0

1 5 . 0 0

2 0 . 0 0

2 5 . 0 0

3 0 . 0 0

3 5 . 0 0

4 0 . 0 0

4 5 . 0 0

5 0 . 0 0

1 9 7 61 9 7 8

1 9 8 01 9 8 2

1 9 8 41 9 8 6

1 9 8 81 9 9 0

1 9 9 21 9 9 4

1 9 9 61 9 9 8

2 0 0 02 0 0 2

2 0 0 42 0 0 6

M a r g i n a l R a t e S t a t u t o r y R a t e

Note: The U.S. federal average marginal dividend tax rate (the blue line) is the dollar weighted average marginal individual dividend income tax as calculated by the NBER TAXISM model from micro data for a sample of U.S. taxpayers. Detailed information about the construction of this variable can be found at http://www.nber.org/~taxsim/marginal-tax-rates/federal.html. The statutory dividend tax rate is computed as the net top statutory dividend income tax rate to be paid at the shareholder level in the U.S., taking account of all types of reliefs and gross-up provisions at the shareholder level. Detailed information about the construction of this variable can be found at the OECD tax database (http://www.oecd.org).

58

Figure 2: New Business Formation in the United States Panel A

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Tax

Rat

e (%

)

500

520

540

560

580

600

620

640

660

680

# of

Firm

s (0

00s)

Dividend Tax Rate # of New Firms

Note: The data on new business formation is from U.S. Small Business Administration (SBA) and is based on information from the U.S. Census Bureau (http://www.sba.gov/advo/research/dyn_b_d8904.pdf). The data on dividend tax rate is from the U.S. federal average marginal dividend tax rate is the dollar weighted average marginal individual dividend income tax as calculated by the NBER TAXISM model from micro data for a sample of U.S. taxpayers. Detailed information about the construction of this variable can be found at http://www.nber.org/~taxsim/marginal-tax-rates/federal.html.

Panel B

0

1

2

3

4

5

6

7

1995 1997 1999 2001 2003 2005

Inte

rest

rate

(%),

GD

P G

row

ith (%

), A

ggre

gate

Mkt

Boo

k (R

atio

)

560

580

600

620

640

660

680#

of F

irms

(000

s)

Interest Rate Aggregate M/B Real GDP Growth # of New Firms

Note: Real GDP Growth is the annual growth rate in real GDP (in percentage points). Interest rate is the one-year Treasury bill rate (in percentage points), Aggregate market-to-book ratio is the ratio of total market value of equity to total book value of equity for firms in COMPUSTAT.

59