The Impact of Shareholder Taxation on Mergers and Acquisitions

Abstract

Mergers are an important part of the US economy. Successful mergers efficiently reallocate capital, capture positive synergies, and exploit economies of scale. However, inefficient mergers dampen innovation and decrease efficiency. We demonstrate, within a neoclassical model, that inefficient acquisitions can become value-maximizing to shareholders when dividend tax rates are higher than capital gains tax rates. This tax wedge allows shareholders to free trapped equity, providing a tax discount to acquisitions. We test this mechanism using variation in the dividend tax rate before and after 2003. Our results suggest that acquiring firms performed 14 percent better after the dividend tax rate was reduced in 2003. These results are especially stark given the sheer magnitude of merger and acquisition activity in the US economy, which in 2014 reached $1.6 trillion.