Dividend and capital gains taxation under incomplete markets

Motivated by the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003, the effects of capital income tax cuts are investigated in an economy with heterogeneous households and a representative, mature firm. Dividend tax cuts, contrary to capital gains tax cuts, lead to a decrease in investment and capital. This is because they increase the market value of existing capital and households require a higher return to hold this additional wealth. In line with empirical evidence, the model predicts substantial increases in dividends and stock prices. Overall, the tax cuts lead to a welfare reduction equivalent to a consumption drop of 0.5%.