Taxes, financial markets and the great moderation

Abstract

Recent studies have shown that there was a noticeable decline in the US corporate sector business cycle volatility from roughly the mid-1980s until the start of the recent financial crisis in 2007. This fact came to be known as the Great Moderation. During the same period, tax rates on US corporate distributions fell roughly from 43% to 17% as a result of the changes in the US income tax system that took place in early 1980s. Motivated by these, we investigate the effects of dividend tax cuts on macroeconomic volatility. We develop a model in which firms finance investment through external equity and internal funds, and face costs of reducing labor input. Dividend taxes reduce the amount of external equity that new firms raise, so they start small and grow over time by using internal funds to a greater extent. Such financially constrained firms respond more to the business cycle shocks since they are affected less from labor reduction costs because of their growing labor demand on their life cycle. Contrarily, old and large firms respond less to business cycle shocks since they completed their growth process, therefore are affected more from labor reduction costs. Lower dividend taxes induce firms to issue more external equity and become financially unconstrained in a shorter amount of time, so there are fewer small, volatile firms, and therefore lower volatility in macroeconomic indicators.