Dividend and capital gains taxation under incomplete markets

Abstract

Abstract Motivated by the Jobs and Growth Tax Relief Reconciliation Act of 2003, we study the effects of capital income tax cuts in a framework where firms make investment decisions to maximize their market value and households are subject to uninsurable labor income risk. We find that the effects of capital gains tax cuts are qualitatively similar to those found in the absence of household heterogeneity. However, dividend tax cuts surprisingly lead to a reduction in aggregate investment. This is because they increase the market value of the existing capital. In equilibrium, households then require a higher return to hold this additional wealth, leading to a lower capital stock. This also implies that dividend tax cuts are welfare reducing in the long run, not only because of the traditional reasons of redistribution from poor to rich, but also because of a fall in aggregate output and consumption. Taking into account the transition mitigates the losses but the JGTRRA tax cuts still lead to a welfare reduction equivalent to a 0.5% drop in consumption. In line with empirical evidence, the model also predicts substantial increases in dividends and stock prices following the tax cuts