Valuation Weights Research Articles

Dividend Taxation in Firm Valuation: New Evidence

In this paper we develop a residual-income model showing how taxes on dividends affect the relative valuation of retained earnings versus contributed equity, as well as the value of expected future earnings. Tests of predictions from our model for a sample of Compustat firms from 197594 suggest that overall firm value, and the relative valuation weights investors assign to retained earnings, contributed equity, and current earnings, all critically depend on dividend taxes. The findings also suggest that investors take a proprietary perspective in valuation and impute an unrecorded shareholder-level tax liability on retained earnings. The U.S. tax system subjects retained earnings to dividend taxes upon distribution to shareholders, while contributed equity is returned to shareholders as a nontaxable return of capital. From the shareholder's (proprietary) perspective, therefore, retained earnings should be valued on