Firm Heterogeneity and the Long-Run Effects of Dividend Tax Reform

What is the long-run effect of dividend taxation on aggregate capital accumulation? To address this question, we build a dynamic general equilibrium model in which there is a continuum of firms subject to idiosyncratic productivity shocks. This firm heterogeneity generates a cross-sectional distribution of firms, with some firms behaving according to the traditional view of dividend taxation and other firms behaving according to the new view of dividend taxation. Specically, at any point in time, a firm may lie in one of three finance regimes: dividend distribution regime, liquidity constrained regime, and equity issuance regime. These finance regimes may change over time in response to idiosyncratic productivity shocks. Firms in different finance regimes respond to dividend taxation in different ways. Our model simulations show that when both dividend and capital gains tax rates are cut from 25 and 20 percent, respectively, to the same 15 percent level permanently, the aggregate long-run capital stock increases by about 3 percent.