Dividend and Corporate Taxation in an Agency Model of the Firm

by R. Christopher Small, for The Harvard Law School Forum at Harvard Law School, Febraury 5, 2010.

In our paper Dividend and Corporate Taxation in an Agency Model of the Firm, which is forthcoming in the American Economic Journal: Economic Policy, we propose a simple model based on the agency theory of the firm (Jensen and Meckling 1976) that provides an alternative to the two leading theories of corporate taxation – the “old view” (Harberger 1962, 1966, Feldstein 1970, Poterba and Summers 1985) and the “new view” (Auerbach 1979, Bradford 1981, King 1977). Our model is motivated by empirical studies of the 2003 dividend tax reform in the U.S. (e.g. Chetty and Saez 2005), which found that: (1) the 2003 dividend tax cut caused large, immediate increases in dividend payouts, and (2) the increases were driven by firms with high levels of share ownership among top executives or the board of directors. These empirical findings are difficult to reconcile with the two leading theories of corporate taxation.

The critical new feature of our model is a divergence between the preferences of managers and shareholders. We model this divergence as arising from perks and pet projects, although the underlying source of the conflict between managers and shareholders does not matter for our analysis. Shareholders can provide incentives to managers to invest and pay out dividends through costly monitoring and pay-for-performance. Only the large shareholders of the firm choose to monitor the firm in equilibrium (Shleifer and Vishny 1986, 1997). In this model, a dividend tax cut leads to an immediate increase in dividend payments because it increases the manager’s preference for dividends relative to the pet project and increases the amount of monitoring by large shareholders. Firms where managers place more weight on profit maximization – either because the manager owns a large number of shares or because there are more large shareholders – are more likely to increase dividends in response to a tax cut…(continue reading)

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