Corporate Investment and Dividend Decisions under Differential Personal Taxation

Abstract

This paper explores implications of differential personal taxation for corporate investment and dividend decisions. The personal tax advantage of dividend deferral causes sharehold? ers to generally prefer greater investment in real assets under internal as opposed to exter? nal financing. Furthermore, dividend deferral is shown to be costly at the corporate level, causing shareholders in different tax brackets at times to disagree over optimal investment and dividend policies under internal financing. The profitability of internally-financed se? curity investment is shown to depend on a security's tax status and shareholders' tax brackets. However, externally-financed security purchases are unprofitable from a tax standpoint. This paper explores the relation between cash dividend payouts and firm investment in real assets, given a personal tax disadvantage to dividends, an is? sue that has received scant attention in the finance literature. In contrast to the prior work of Auerbach (1979), (1984), this study formally introduces differen? tial personal tax rates and uncertainty, demonstrates the personal tax disadvan? tage of early dividend payouts, and analyzes both the impact of a diminishing returns to scale technology for firm investment in real assets and the impact of double corporate taxation for firm investment in financial claims. The model de? veloped here yields several predictions for corporate dividend and investment decisions that are consistent with those derived from the existing agency and signalling models,1 as well as several additional predictions. A key property of this paper's model is a firm's limited ability to costlessly defer the payout of earnings as a cash distribution to shareholders, whether