Dividend Taxation and the Cost of New Share Issues

It has generally been accepted in earlier research that the dividend tax reduces the rate of return to investments financed by new issues of equity, and hence raises the cost of capital. Still, and virtually without discussion, the existing literature has come to widely diverging conclusions about the size of the tax distortion. We demonstrate that the extent to which shareholders can recover their original equity injections without being subject to tax is a key factor in determining the cost of new equity. Our analysis explains for the first time why the earlier literature has come to diverging conclusions about the size of the tax distortion.