The Cost of Misaligned Tax Incentives: Evidence from Tax-Motivated Special Dividends

Abstract

Prior research finds that firms pay special dividends before a dividend tax increase. We examine the funding sources and real effects of these tax-motivated special dividends, finding that firms incur costs – reducing investment and repurchases – to pay them. The funding sources, and related real effects, vary with shareholders’ tax incentives. When tax-insensitive institutional investors likely influence the dividend to benefit firms’ taxable shareholders other than insiders, firms reduce repurchases and capital expenditures. Conversely, when taxable insiders likely influence the dividend, and their tax incentives are misaligned with firms’ primarily tax-insensitive shareholder base, firms reduce R&D, consistent with misaligned payouts signaling managerial myopia which erodes shareholder value. Tests using both market responses to, and total factor productivity changes around, tax-motivated special dividends support these conclusions. These findings add to our understanding of tax-based agency issues influencing real corporate decisions and identify a previously unexplored cost of dividend tax increases.