Mitigating shareholder taxation in small open economies

This article reconsiders the role of dividend taxation and its effect on the cost of capital of small firms. Using a simple portfolio model for small open economies, we show that a decrease in dividend taxes on large companies unambiguously increases the required rate of return for small companies. A dividend tax cut for both, large and small companies may however lead to the counter-intuitive result of increasing cost of capital for small firms. For different small open economies, we further provide statistics on the correlation between the return of large and small firms that drives the counter-intuitive result. Our results suggest that mitigating payout taxes in small open economies can have ambiguous effects on the cost of capital of small, domestically owned firms. This is particularly relevant when tax reforms are designed to stimulate investments by small firms scarce in internal funds.