# Dividend tax capitalization and liquidity

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## Abstract

We provide a new explanation for cross-sectional variation in dividend tax capitalization. Our analysis is twofold. First, we conduct a theoretical analysis that shows that liquidity (illiquidity) mitigates (magnifies) the positive effect of dividend taxes on expected rates of return documented in prior literature. Second, we conduct an empirical analysis centered around the Jobs and Growth Tax Relief and Reconciliation Act of 2003, which reduced the difference between the maximum statutory dividend and capital gains tax rates, and find results consistent with our theory. We also provide results suggesting that institutional ownership’s mitigating effect on dividend tax capitalization documented in prior studies is attributable to stocks with greater institutional ownership being more liquid and not to the “marginal investor” being insensitive to dividend taxes.

## Keywords

Dividend taxes Liquidity Tax capitalization Expected rate of return## JEL Classification

G12 G35 H24 K34 M41## Notes

### Acknowledgments

The authors thank Peter Easton, Luzi Hail, Richard Sansing, Pavel Savor, and participants at the 2012 UNC Tax Symposium and 2012 American Taxation Association Mid-Year Meeting for helpful comments.

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