Transitional Dynamics of Dividend Tax Reform

We develop a dynamic general equilibrium model to study the impact of the 2003 dividend and capital gains tax cuts. Firms are heterogeneous in productivity and make investment and financing decisions subject to capital adjustment costs, equity issuance costs, and collateral constraints. Our calibrated model predicts that when the tax cuts are unexpected and temporary, dividend payments rise immediately by about 35 percent (relative to the level in the initial steady state). In the expiration date of the tax cuts, dividend payments decrease by about 15 percent. Aggregate investment decreases in the periods when the tax cuts are implemented, leading to an 11 percent drop in the period immediately prior to the expiration date of the tax cuts.