The Impact of Progressive Dividend Taxation on Investment Decisions: Working Paper 2008-03

Maria I. Marika Santoro and Chao D. Wei

In this paper, we study the distortionary impact of progressive dividend taxation on dynamic investment decisions under the "new view" of dividend taxation. We use a stochastic general equilibrium model to examine the qualitative and quantitative importance of the distortion. We find that the theoretical irrelevance of dividend taxation advocated by the new view does not hold when dividends are taxed progressively in an economy with uncertainty. In such an economy, dividend taxation introduces a wedge between the marginal cost and benefit of investment. The distortion is caused by endogenous variations in the marginal tax rates over the business cycle, and is absent if dividend taxes are proportional. We find that the magnitude of distortion critically depends upon the progressivity of the tax system. We calibrate our model to quantify the importance of the distortion for an income tax system as progressive as the one in the United States. We find that the progressivity of such a tax system is too small for the distortion caused by dividend taxation to be quantitatively important for investment decisions.