Dividend Taxes and Stock Volatility

Abstract

How do dividend taxes affect stock volatility? In this paper, I use a decrease in dividend taxes as a natural experiment to identify their impact on firm's price volatility.If a risk-averse executive faces price risk through his incentive contract, changes in stock volatility due to dividend taxes may increase agency costs and therefore decrease overall welfare. Stock volatility decreased after the tax cut for firms where an executive has large holdings of shares and options relative to firms where an executive has small holdings of shares and options. Therefore, with a risk-averse executive and risk-neutral shareholders, dividend taxes may exacerbate agency costs. The increase in agency costs will decrease shareholder welfare, which can be partially offset by the use of options in the employment contract. *