Fundamentals of Shareholder Tax Capitalization

We examine the current accounting controversy over dividend tax capitalization using a model in which we model explicitly the investment and dividend policies of the firm. We measure dividend tax capitalization using Tobin's q. Our analysis shows that the effect of dividend taxes on Tobin's q depends on whether the firm is in a growth stage or a mature stage, as well as on whether earnings are distributed to shareholders via dividends, stock repurchase, or liquidation. Tobin's q for a firm in the growth stage is increasing in the dividend tax rate, and q is greater than one. When dividend irrelevance occurs for mature firms, q becomes less than one. If earnings are distributed via stock repurchases instead of dividends, q exceeds one. We also show that investor-level taxes can either increase or decrease the value of retained earnings relative to contributed capital, depending on the stage of the firm's life cycle and how earnings are distributed