Do Tax-Exempt Investors Mitigate the Dividend Tax Penalty?

28 Pages Posted: 23 Feb 2006

See all articles by David A. Guenther

David A. Guenther

University of Oregon - Department of Accounting

Richard C. Sansing

Tuck School of Business at Dartmouth

Date Written: February 13, 2006

Abstract

We investigate the effect of shareholder taxes on expected stock returns using a model that characterizes both the optimal portfolios of taxable and tax-exempt investors and the expected rates of return on risky stocks. When all income is taxed at the same effective rate, each investor's ownership in each risky stock depends only on that investor's relative tolerance for risk. Taxes induce taxable investors to hold more of the tax-favored stock, but risk-sharing considerations induce each investor to hold some stock unless the riskiness of the stock is sufficiently low. There is no "marginal investor" in this case. Each stock's expected return reflects a "dividend tax penalty," but the dividend tax penalty is not mitigated by the fraction of shares held by the tax-exempt investors. Although the presence of the tax-exempt investors in the market does mitigate the dividend penalty for the market as a whole, this effect is identical for all firms held by both taxable and tax-exempt investors and does not vary with the fraction of shares held by the tax-exempt investors.

Keywords: Dividend tax capitalization, tax clienteles, tax-exempt investors, implicit taxes

JEL Classification: G12, G35, H24

Suggested Citation

Guenther, David A. and Sansing, Richard C., Do Tax-Exempt Investors Mitigate the Dividend Tax Penalty? (February 13, 2006). Tuck School of Business Working Paper No. 2006-32. Available at SSRN: https://ssrn.com/abstract=883627 or http://dx.doi.org/10.2139/ssrn.883627

David A. Guenther

University of Oregon - Department of Accounting ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States
541-346-5384 (Phone)

Richard C. Sansing (Contact Author)

Tuck School of Business at Dartmouth ( email )

100 Tuck Hall
Hanover, NH 03755
United States
603-646-0392 (Phone)
603-646-1308 (Fax)

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