Agency Problems, Investment Policy, and Dividend Taxation

Abstract

We develop an intertemporal firm model that illustrates how dividend taxation interacts with dividend policy and investment efficiency in different stages of a firm's growth process. Our results show that a cut in the dividend tax rate may increase investment efficiency by increasing the return that public investors can receive from monitoring and disciplining management. In the mature firm in which free cash-flow is inefficiently invested instead of paid out, a dividend tax cut will make investors demand higher dividends and will hence reduce the inefficient overinvestment. The model is build in the tradition of Jensen's (1986) free cash-flow hypothesis and on the literature on dividend policy and agency problems within a corporate governance framework. While our infant firm is unaffected by changes in dividend taxation, the dividend tax rate influences the duration of the growth phase of the firm and the investment behaviour in the mature firm. Our results are are in line with the old view of dividend taxation in that they predict the negative relationship of dividends and the dividend tax rate. The negative relationship between the dividend tax rate and the investment behaviour in the mature firm contradicts both the old and the new view of dividend taxation, however. This can be attributed to the fact that we incorporate agency problems into our model, a feature that both views abstract from. Supported by an increasing amount of empirical literature that finds indicators for agency problems within firms and for overinvestment tendencies, our modelling approach yields results that are compatible with Chetty and Saez (2005) analysis of the 2003 dividend tax cut in the United States.

Keywords: Dividend Taxation, Investment Policy, Corporate Governance

JEL Classification: G32, H32