Dividends and Capital Gains Taxation under Incomplete Markets

Abstract. The capital income tax cuts that were part of the Jobs and Growth Tax Relief Reconciliation Act of 2003 are expiring this year and the administration has to decide whether to extend them or not. This paper assesses the effects of these tax cuts in a calibrated dynamic general equilibrium framework with uninsurable labor income risk. In particular, it looks at the effects of dividend (and capital gains) taxes on investment and welfare in a framework where firms are the owners of capital and make investment decisions to maximize their market value. While the effects of capital gains taxes are qualitatively similar to those found when households own the capital, we find that the effects of dividend taxes are different. A dividend tax cut leads to a reduction in investment, since it reduces the uncertain part of income (labor) relative to the safe part. As a result, the precautionary savings motive is weaker and firms, acting in the interest of households, invest less in capital. In the long run, dividend tax cuts are welfare reducing, not only because of the traditional reasons of redistribution from the poor to rich, but also because of a fall in aggregate production and consumption. Taking into account transition effects mitigates the losses. Using our benchmark calibration