Dividend and Corporate Taxation in an Agency Model of the Firm

Recent empirical studies of dividend taxation have found that: (1) dividend tax cuts cause large, immediate increases in dividend payouts, and (2) the increases are driven by firms with high levels of share ownership among top executives or the board of directors. These findings are inconsistent with existing theories of dividend taxation. We show that an agency model in which managers and shareholders have conflicting interests explains the evidence. In this model, dividend taxation encourages managers to divert earnings into unproductive projects instead of paying out profits to shareholders and therefore creates a first-order deadweight cost. In contrast, corporate taxes do not distort the manager’s choice between payouts and unproductive investment and may only create second-order efficiency costs. Corporate income taxation may therefore be a more efficient way to generate revenue than dividend taxation, challenging existing intuitions based on neoclassical models. ∗Raj Chetty, [email protected], Harvard University, Department of Economics, Cambridge, MA 02138. Emmanuel Saez, [email protected], University of California Berkeley, Department of Economics, 549 Evans Hall #3880, Berkeley, CA 94720. We thank Alan Auerbach, Martin Feldstein, Roger Gordon, Kevin Hassett, James Poterba, two anonymous referees, and numerous seminar participants for very helpful comments. Gregory Bruich, Joseph Rosenberg, and Ity Shurtz provided outstanding research assistance. Financial support from National Science Foundation grants SES-0134946 and SES-0452605 is gratefully acknowledged.