Dividend Policy, Taxes and Agency Problems

Chatty and Saez (2004) argued that more Principal-Agent models explaining firm dividend policy are expected and subsequently offered a model of dividend policy that includes a tax on dividends and agency problems (Chatty and Saez (2007)). In this paper we extent their model by adding a tax on capital gain and also by introducing a tax authority that selects optimal tax rates for dividends and capital gains. A moral hazard/free cash flow problem exists with regard to the use of retained earnings. Firms may pay dividends to reduce the extent of agency probems related to investment in inefficient projects that can also lead to underinvestment in efficient projects. Our model predicts that a higher dividend tax rate as compared to capital gain tax can reduce this inefficiency. The paper also generates several empirical predictions regarding firm dividend policy and managerial compensation