Investor-level taxation may distort merger and acquisition decisions when capital gains are taxed at a preferable rate, relative to dividends. The intuition is that the value of a target’s assets depends on whether the target is acquired. If it is acquired, then the firm’s equity is taxed at the capital gains rate. If, instead, the target is not acquired, then eventually the equity will be distributed as dividends and taxed at the dividend tax rate. This tax discount means acquisitions have a tax preference, relative to dividend payments, for potential acquiring firms that pay dividends. As a result, the tax discount distorts the mergers and acquisitions of dividend-payers, leading them to do more and lower quality deals. To test for the existence and effects of this tax discount on merger and acquisition behavior, we exploit quasi-experimental variation created by the Jobs Growth and Tax Relief Reconciliation Act of 2003, which equalized dividend and capital gains rates, eliminating the tax discount. We find that acquiring firms with larger tax discounts before 2003 made higher quality acquisitions after the discount was eliminated. These results support the existence of a tax discount prior to 2003 and suggest that re-implementing the same wedge between dividend and capital gains rates would cause lower quality acquisitions that would destroy approximately $59 billion of the value of mergers and acquisitions in the United States annually.
Author(s): Eric Ohrn, Nathan Seegert