Dividends and Shareholder Taxation: Evidence from Canada∗

The effect of dividend taxes on dividend payments is a topic of considerable debate with repercussions for the cost of capital and investment. The traditional view of dividends suggests that dividend taxes lead to lower dividends, a higher cost of capital and so lower investment. In contrast, according to the new, or trapped equity, view, dividend taxes are neutral to dividend payout, the cost of capital and investment. I test these theories using firm-level panel data surrounding a recent policy change in Canada. This reform cut the shareholder-level tax rate on dividends for top tax bracket investors by about 40%. Analysis of discrete dividend events (initiations, terminations, increases and decreases) suggest little effect from the dividend tax cut, in stark contrast with recent evidence from the United States. Difference-in-differences estimates using control groups comprised of firms which were exogenously unlikely to be affected by the reform suggest a small positive effect on net dividend initiations. Finally, fixed effect models of the level of regular dividends, which are highly concentrated among the largest payers, show some evidence of an increase around the reform. However, the type of firms responding casts serious doubt on taxes as the explanation for this phenomenon. These results are consistent with the small and open nature of the Canadian economy, and have important consequences for the effects of globalization on shareholder taxation. ∗I would like to thank Michael Smart, Robert McMillan, Laurence Booth and Alex Edwards for their guidance and support throughout this project. I gratefully acknowledge financial support from the SSHRC CGS Doctoral Fellowship, the Dorothy J. Powell Graduate Scholarship in International Economics and the Royal Bank Graduate Fellowship in Public and Economic Policy. All omissions and errors are my own. †E-mail: [email protected].