Introduction

Recent changes to the taxation of company dividends in the UK provide an opportunity to investigate empirically how dividend taxes affect firms' dividend policies, cost of capital, and investment. Prior to July 1997, the UK tax system was unusual in that a major class of shareholders – UK pension funds and insurance companies managing pension-related assets – had a more favorable tax treatment of dividend income than capital gains. Tax credits, which reduced personal income tax on dividends for tax-paying shareholders, were repaid to these tax-exempt funds. This position changed sharply in July 1997. Although dividend tax credits remained for taxpayers, they were no longer refundable to UK pension funds and insurance companies. After July 1997, these institutional investors had an equal tax treatment of dividend income and capital gains. This chapter studies the effects of this tax reform on the dividend payments and investment spending of quoted nonfinancial UK companies.

In a companion paper, we argue that domestic dividend taxation has little or no effect on the stock market valuation of UK companies. This reconciles the fact that pension funds and insurance companies owned around half the equity in quoted UK firms before July 1997, with the fact that there was no sharp fall in the UK stock market around the time when these repayable tax credits were abolished. The theoretical argument is straightforward and consistent with standard asset pricing models when investors have heterogeneous tax rates.