Dividend taxes and investment efficiency: Evidence from the 2003 U.S. personal taxation reform

We examine the effect of a large dividend tax cut on corporate investment efficiency by exploiting the 2003 personal taxation reform in the U.S. as a quasi-natural experiment. Using a difference-in-differences approach based on the probability that a firm's marginal investor was an individual investor, we show that the 2003 dividend tax cut significantly improved the investment efficiency of U.S. listed firms. However, we find no evidence that the dividend tax cut increased the level of investment of U.S. listed firms. Further, we show that the tax cut increased investment efficiency by mitigating agency problems associated with the excessive free cash flows of overinvesting firms and by relaxing the financial constraints of underinvesting firms.