A Principal-Agent View on Dividend Taxation and Investment Efficiency

We propose an equity finance model with agency problems and investigate the relationship between dividend taxation and inefficient investments. Contrary to both the old and the new view of dividend taxation, a fall in the dividend tax rate is found to improve corporate governance by increasing dividends and limiting inefficient overinvestments. These results are derived both in a two-period framework and in more general cases withmultiple periods with perfectly informed and uninformed, but learning investors. The predictions of our model are confirmed empirically in a cross-sectional panel analysis of 4,272 firms between 1980 and 2005. The data also supports the prediction that uncertainty ab out the firm`s expected rate of return further lowers inefficient overinvestments.