Incremental Financing Decisions and Time-Series Variation in Personal Taxes on Equity Income

Abstract

This study investigates whether changes in personal tax rates on dividends and capital gains affect firms' incremental financing decisions. The evidence in this study suggests that following the 1997 and 2003 Tax Acts, which decreased tax rates on equity income, firms are less likely to issue debt relative to equity, consistent with the expectation that decreases in tax rates on equity income decrease the tax benefits of debt. Further, the magnitude of this effect varies predictably with dividend yield, a proxy for the proportion of equity income taxed at capital gain tax rates versus dividend tax rates. The magnitude of this effect is also decreasing in institutional ownership, a proxy for the probability that the marginal investor is tax exempt. This paper contributes to the literature that examines the effect of taxes on corporate financing decisions.

Keywords: capital structure, dividend taxes, capital gain taxes, corporate taxes

JEL Classification: H24, G32, G35, L31