Taxation of dividend income and economic growth

Recently, researchers have turned to analyzing how the tax structure, rather than the overall tax level, affects economic performance. For instance, several papers have investigated how the taxation of corporate and individual (labor) income influences growth. The taxation of dividend income may also influence growth via its impact on investments and firm behavior. Within the academic community, there are conflicting views about the impact that taxation of dividends has on firm behavior and, hence, on economic performance. According to the “new view”, the taxation of dividends does not influence the marginal cost of capital and consequently has no impact on investment decisions. According to the “old view”, the taxation of dividends is distortionary and increases the cost of equity. In the “agency view”, an underlying cause of this distortionary effect is principal-agency problems between management and owners, resulting in social costs due to the inefficient use of locked-in capital. Even though there is no consensus among the "views", the different "views" are likely to influence different types of firms. Firms that can retain profits may operate according to the new view while new start-ups lacking profits to reinvest are more likely to operate according to the old view. This paper investigates whether dividend taxation not only affects firm behavior but also affects the macro-economy. To our knowledge, this paper is the first study to explore how taxation of dividend income affects economic growth. We do this by using panel data from 1990 to 2008 for 18 European countries. In addition to economic growth we also study how dividend and other income taxes affect R&D and firm creation in order to investigate the underlying mechanisms. We find that the taxation of dividend income negatively influences economic growth, a result that corroborates the “old view” of dividend taxation as distortionary. We do not find the same negative correlation between economic growth and taxation of labor and corporate income. Data sources include the OECD tax database, International Bureau of Fiscal Documentation (IBFD), and the European Tax Handbook.