Dividend Taxes and Implied Cost of Capital

Abstract

We estimate firms' implied cost of capital and examine the effects of dividend taxes on this ex ante measure. The results support the dividend tax capitalization hypothesis. We find a positive relation between implied cost of equity capital and dividend yield that is decreasing in aggregate institutional ownership. We further explore the effect of institutional ownership on the dividend tax premium by partitioning institutional owners into groups of homogeneous investors. We find evidence that ownership by certain groups of tax-favored institutions, including insurance companies, endowments, and pensions, decreases the dividend tax premium and that ownership by mutual funds, non-tax-favored institutions, does not significantly affect the dividend tax premium. Although banks do not face the dividend tax penalty that individual investors face, we do not find that the dividend tax premium is decreasing in ownership by banks, contrary to our predictions. We believe that this exploration paves the way for future research that can identify stronger settings within which to examine the effects of institutional owners' tax attributes on the dividend tax premium.

JEL Classification: G12, H24, H25, G35, G21