TY - JOUR AU - Chen,Chongyang AU - Dai,Zhonglan AU - Shackelford,Douglas AU - Zhang,Harold TI - Does Financial Constraint Affect Shareholder Taxes and the Cost of Equity Capital? JF - National Bureau of Economic Research Working Paper Series VL - No. 17169 PY - 2011 Y2 - June 2011 UR - http://www.nber.org/papers/w17169 L1 - http://www.nber.org/papers/w17169.pdf N1 - Author contact info: Chongyang Chen School of Management, The University of Texas at Dallas Richardson, TX 75080-3021 E-Mail: cchen@utdallas.edu Zhonglan Dai School of Management The University of Texas at Dallas Richardson, TX 75080-3021 E-Mail: zdai@utdallas.edu Douglas Shackelford University of North Carolina at Chapel Hill Kenan-Flagler Business School Campus Box 3490, McColl Building Chapel Hill, NC 27599-3490 Tel: 919/962-3197 Fax: 919/962-4727 E-Mail: doug_shack@unc.edu Harold Zhang University of Texas at Dallas E-Mail: harold.zhang@utdallas.edu AB - We show that firms with the least elastic demand for equity capital should benefit the most from reductions in shareholder taxes. Consistent with this prediction, we find that, following 1997 and 2003 cuts in U.S. individual shareholder taxes, financially constrained firms, and particularly those with disproportionate ownership by U.S. individuals, enjoyed larger reductions in their cost of equity capital than did other firms. The results are consistent with the incidence of the tax reductions falling mostly on firms with the most pressing needs for capital. Furthermore, the findings provide an explanation for the heretofore puzzling finding that, following the unprecedented 2003 reduction in dividend tax rates, non-dividend-paying firms outperformed dividend-paying firms. Not surprisingly, we find that non-dividend-paying firms are more financial constrained than dividend-paying firms are. When a firm’s financial constraint and dividend choice are jointly considered, we find that the extent of financial constraint affects the change in the cost of equity capital, but whether a firm issues a dividend does not. In other words, it appears that the extant studies suffered from the omission of a correlated variation, the extent to which a firm is financially constrained. ER -