This paper offers a new explanation of the dividend pizzle, based upon a
model in which firms attempt to signal profitability by distrbuting cash to
shareholders. I assume that dividends and repurchases are identical, except
that dividends are taxed more heavily. Nevertheless, I demonstrate that,
under certain plausible conditions, corporations will pay dividends. Indeed,
some firms will actually pay dividends, and then retrieve a portion of these
payments by issuing new equity (perhaps through a dividend reinvestment
plan), despite the fact that this appears to create gratuitous tax
liabilities. In addition to providing an explanation for the dividend
puzzle, I also derive a number of strong results concerning corporate payout
decisions and government tax policy. Some of these results are surprising.
For example, the relationship between repurchases and firm quality is hump-shaped.
Moreover, despite the fact that a higher dividend tax rate depresses
dividend payments, it does not affect either government revenue or welfare.
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