The Vanishing Harberger Triangle

The paper presents a trapped equity model, but instead of studying how taxes affect corporate decisions when a sufficient amount of equity is already in the trap, it asks the question how does the equity get there. To be more specific, the paper analyzes how the double taxation of dividends affects the growth of a corporation that starts with no equity capital. One conclusion is that dividend taxes are distortionary <i>before</i> they are paid, but not <i>when</i> they are paid. Once the firm is in a stage of maturity where it pays dividends and dividend taxes, tax neutrality prevails. Thus the true intersectoral distortion resulting from corporate taxation is negatively correlated with the measured tax burden, and it is lower, the higher the distortion which estimates of Harberger type would predict. Another conclusion is that the King-Fullerton cost of capital formulae are not applicable in the case of immature firms. These formulas are based on the assumption that firms distribute their profits from marginal investment projects as dividends. However, immature firms strictly prefer a reinvestment to a distribution of profits. The reinvestment changes the cost of equity capital, and typically this cost is higher than a hasty application of the King-Fullerton formulas would predict