Nonlinear Dividend Tax and the Dynamics of the Firm

We analyze the implications of a nonlinear tax scheme for dividends using a life-cycle model of a firm. In this model new firms first enter markets; then grow internally, financing from retained earnings; and finally distribute their profits in the steady state. We find that under a nonlinear tax the owners prefer a smooth flow of dividends, which encourages firms to begin distributions right from the start. This early-distribution incentive (EDI) slows down investments and leads to delayed growth. Our calculations indeed confirm that a revenue-neutral switch from a linear to a progressive tax exacerbates production losses. We further demonstrate that this distortion can be reduced by carrying forward unused tax allowances with interest, as proposed e.g. by Mirrlees et al. (2011).