Abstract - The Impact of Financial Constraints on the Relation between Shareholder Taxes and the Cost of Equity Capital

Using both the Tax Relief Act of 1997 (TRA) and the Jobs and Growth Tax Relief and Reconciliation Act of 2003 (JGTRRA), we conduct the first empirical investigation on how the tax cuts on dividends and/or capital gains affect the cost of equity differently for firms facing different degrees of financial constraints. We show that firms which have more pressing needs for capital and thus are more financially constrained experience a larger reduction in the cost of equity when tax rates (capital gains tax and/or dividend tax) are reduced; non-dividend paying but financially constrained firms experience the largest cost of equity capital reduction when only capital gains tax rate is cut (TRA). When the dividend tax rate cut is much larger than the capital gains tax rate cut (JGTRRA), more financially constrained high dividend yield firms experience a larger reduction in the cost of equity capital than less financially constrained low dividend yield firms. Taking together, the evidence suggests that, in general, more severely financially constrained firms benefit the most from tax cuts, indicating that both tax acts have achieved their intended objectives.

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