Does Financial Constraint Affect Shareholder Taxes and the Cost of Equity Capital?

Working Paper: NBER ID: w17169

Authors: Chongyang Chen; Zhonglan Dai; Douglas Shackelford; Harold Zhang

Abstract: We show that firms with the least elastic demand for equity capital should benefit the most from reductions in shareholder taxes. Consistent with this prediction, we find that, following 1997 and 2003 cuts in U.S. individual shareholder taxes, financially constrained firms, and particularly those with disproportionate ownership by U.S. individuals, enjoyed larger reductions in their cost of equity capital than did other firms. The results are consistent with the incidence of the tax reductions falling mostly on firms with the most pressing needs for capital. Furthermore, the findings provide an explanation for the heretofore puzzling finding that, following the unprecedented 2003 reduction in dividend tax rates, non-dividend-paying firms outperformed dividend-paying firms. Not surprisingly, we find that non-dividend-paying firms are more financial constrained than dividend-paying firms are. When a firm's financial constraint and dividend choice are jointly considered, we find that the extent of financial constraint affects the change in the cost of equity capital, but whether a firm issues a dividend does not. In other words, it appears that the extant studies suffered from the omission of a correlated variation, the extent to which a firm is financially constrained.

Keywords: financial constraint; shareholder taxes; cost of equity capital

JEL Codes: G12; G32; G35; H24

Causal Claims

Cause	Effect
Financial Constraints (D20)	Cost of Equity Capital (G31)
Shareholder Tax Reductions (H32)	Cost of Equity Capital (G31)
Financial Constraints + Taxable Status of Shareholders (G32)	Cost of Equity Capital (G31)
Financial Constraints (High Proportion of Individual Investors) (G19)	Cost of Equity Capital (G31)
Non-Dividend-Paying Firms (Financially Constrained) (G35)	Cost of Equity Capital (G31)