Taxes, Financial Markets and the Great Moderation

(Job Market Paper)

In the United States, business cycle volatility has declined during the last two decades. During the same period, tax rates on US corporate distributions fell roughly from 43% to 17% as a result of the changes in the US income tax system that took place in early 1980s. We investigate the extent to which observed changes in macroeconomic volatility can be accounted for by the decline in dividend tax rates. We develop a model in which firms finance investment through external equity and internal funds, and face costs of reducing labor. Dividend taxes reduce the amount of external equity that new firms raise, so they start small and grow over time by using internal funds to a greater extent. Such financially constrained firms respond more to business cycle shocks since they are affected less from labor reduction costs because of their growing labor demand on their life cycle. On the contrary, old and large firms respond less to business cycle shocks since they completed their growth process, therefore are affected more from labor reduction costs. Lower dividend taxes induce firms to issue more external equity and become financially unconstrained in a shorter amount of time, so there are fewer small, volatile firms, and therefore lower volatility in macroeconomic indicators.

Taxes, Regulations and the Corporate Debt Market

In the United States, the outstanding debt in corporate sector, as a fraction of GDP, increased roughly from 53% to 77% in mid-1980s. During the same period, tax rates on US corporate distributions fell roughly from 43% to 17% as a result of the changes in the US income tax system that took place in early 1980s. We investigate the extent to which observed changes in corporate debt markets can be accounted for by the decline in dividend tax rates. We develop a model with borrowing limits, where outstanding debt is constrained by value of corporations. Dividend taxes lower corporate values, therefore outstanding debt of firms. The model accounts for 74% of the increase in outstanding debt in corporate sector.