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Tax Policy and the Dividend Puzzle

B. Douglas Bernheim

NBER Working Paper No. 3434
Issued in September 1990
NBER Program(s):Public Economics

This paper offers a new explanation of the dividend puzzle, based upon a model in which firms attempt to signal profitability by distrubuting cash to shareholders. I assume that dividends and repurchases are identical, except that dividends are taxed more heavily. Nevertheless, I demonstrate that, under certain plausible conditions, corporations will pay dividends. Indeed, some firms will actually pay dividends, and then retrieve a portion of these payments by issuing new equity (perhaps through a dividend reinvestment plan), despite the fact that this appears to create gratuitous tax liabilities. In addition to providing an explanation for the dividend puzzle, I also derive a number of strong results concerning corporate payout decisions and government tax policy. Some of these results are surprising. For example, the relationship between repurchases and firm quality is hump-shaped. Moreover, despite the fact that a higher dividend tax rate depresses dividend payments, it does not affect either government revenue or welfare.

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Document Object Identifier (DOI): 10.3386/w3434

Published: Rand Journal of Economics, Volume 22, No. 4, pp. 455-476, Winter 1991. citation courtesy of

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