Taxing dividends increases investment

After the election of François Hollande as the President of the Republic in 2012, there were serious reforms in capital taxation aimed at bringing it closer to income taxation. Among these reforms, the tax rate on dividends for LLC entrepreneurs was brought into line with wages, namely 46%. The increase is significant, as dividends were previously taxed at a rate of 15.5%.

It is not surprising that right-wing parties and employers’ unions have predicted an economic disaster associated with the announced collapse of investment. Dividends should reward capital providers and reward the risk an investment represents, a tax rate increase should increase the cost of capital (shareholders demand higher returns to offset the tax increase) and discourage entrepreneurs from investing.

Seven years later, it is possible to summarize this reform, which we recently did in a research paper with Charles Boissel, using French administrative data that allow us to study the universe of companies in France. The conclusion is clear: this increase in taxation of dividends did not have a negative impact on the economy. On the contrary, it has led to increased investment and employment!

How can we demonstrate this? Based on the fact that the reform affected only limited liability companies. Thus, comparing the behavior of SARLs with companies with other legal statuses (in particular, joint-stock companies of the simplified type or SAS), before and after the reform, allows us to assess the “causal” effect of the tripling of the dividend tax rate for LLC entrepreneurs.

Less dividends, more investment

This comparison shows that after the reform, SARL entrepreneurs significantly reduced their dividend payments, by about 17%. This effect is the most expected. As the tax rate increases, entrepreneurs will prefer to keep more cash in the company rather than pay out dividends.

What are companies doing with the new cash? We found that, on average, entrepreneurs reinvest 0.3 euros for every euro not distributed as dividends. This means a significant increase in investment!

This increase in investment, caused by the increase in taxation of dividends, leads to a better allocation of capital

However, this increase may be partially counterproductive if these additional investments are concentrated in low-performing projects.

When we analyze in more detail which companies reinvest, we find, on the contrary, that only companies with growth opportunities and the most productive companies invest and develop more. Thus, this increase in investment caused by higher dividend taxation is reflected in a better allocation of capital: companies that are able to generate more wealth for each euro of capital invest and grow faster than companies that are similarly affected by a higher dividend tax rate, but less productive

Of course, it can be assumed that, despite these average positive effects, some companies were affected by the reform. Our ability to observe all companies in France allows us to closely approximate the numerous subgroups predicted by economic theory to be negatively affected: companies that use more equity financing, younger companies, more or less large ones. But nowhere do we observe that an increase in the dividend tax rate has led to a fall in investment.

More cash

If one-third of retained earnings are reinvested, what do companies do with the remaining two-thirds? We found that “tax avoidance” behavior, such as when the company pays for personal consumption (such as buying a “company” car for purely personal use), does not increase.

In fact, two-thirds of the remaining undistributed and unreinvested dividends can be attributed to increased cash and increased loans to the company’s customers. The latter no doubt partly explains why companies hit by a dividend tax increase end up growing faster than companies whose rate remains the same.

Our results contradict the predictions of standard neoclassical models, but they can be explained by three reasons. First, entrepreneurs may on average underestimate future demand, especially during times of troubled economic activity, such as during the European sovereign debt crisis. As a result, they may maintain too little cash to take advantage of investment opportunities as they arise.

Further, the relationship between tax increases and the efforts of economic agents is ambiguous. Indeed, if entrepreneurs want to have a fixed level of consumption despite the increase in taxes, they will be forced to produce more and, in our particular case, invest more.

Interim arbitration

Finally, contrary to the standard assumptions of most economic models, tax changes are not permanent, but, on the contrary, can be perceived as temporary. Political change has become a feature of our democracies, and tax increases introduced by a left-wing government are likely to be defeated by the next right-wing government.

Entrepreneurs therefore have an incentive to do what Anton Korinek and Joseph Stiglitz call “intertemporal arbitrage”: if I know that taxes on my dividends are high today but will decrease in the near future, I have an interest in reducing my dividends. dividends and building up capital in the company during this period to pay me higher dividends when taxes are reduced again. This accumulation of wealth within a company can be done either by holding more cash or by investing when opportunities for growth arise, which is exactly what we are finding.

Our results do not necessarily imply that higher taxes on dividends will lead to increased investment in the long run. Indeed, even if the next government does not revise the tax rate increase, the entrepreneurs who were initially affected by the increase may tire of waiting for the tax rate to decrease and decide to increase their dividend payments again, reducing the cash available for investment.

However, our research implies at least that increased taxation of dividends does not harm investments, but on the contrary, can be used to support them in periods of economic downturn. And if, in the worst case, entrepreneurs simply decide to keep their dividends and investment levels constant, this will always generate additional revenue for the state to finance its public policies.