Dividend Taxes and Firm Valuation: A Re-Examination

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Abstract
Recent evidence and statements in Harris and Kemsley (1999) suggests that shareholder-level dividend taxes on retained earnings are fully impounded at the top statutory rate into stock prices. We re-examine these claims and results. Using the traditional definition of dividend tax capitalization, that asset prices will be lower if the asset returns are subject to higher taxation, we reject the claim that the valuation of retained earnings is reduced because it is subject to future taxes when distributed as dividends. Harris and Kemsley base their predictions and empirical tests on Ohlson (1995). We offer alternative formulations and interpretations of the role of contributed capital, retained earnings, and earnings in the Ohlson (1995) model. Our evidence does not reject dividend tax capitalization but does reject full dividend tax capitalization on retained earnings arising from future dividends being paid from the current stock of retained earnings. We also investigate the crucial role of the ratio of retained earnings to book value in Harris and Kemsley (1999) and report some results inconsistent with their interpretation of dividend taxes on retained earnings.