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 before they are paid, but
not when 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 formulae 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 formulae would predict.
*Published:
Journal of Public Economics, Vol. 45, pp. 271-300, (1991). Edited by A.B. Atkinsona and N.H. Stern, UK.
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