Retained Earnings or External Financing in Tax Systems with Deduction for Notional Interest on Equity

Abstract This paper analyzes the effects of financing new investment projects with retained earnings, newly raised equity, or debt under corporate taxation and personal income taxation of dividends, interest income, and realized capital gains. The analysis is based on a stylized model that extends the classical tax system by introducing a deduction for notional interest on equity – either at the corporate level (Allowance for Corporate Equity, ACE) or at the shareholder level (Shareholder Income Tax, SIT). We show that financing neutrality can be achieved under both tax systems, but only under the same restrictive conditions. Furthermore, our findings highlight that retained earnings, despite leading to the same debt-to-equity ratio as by raising new equity, after payout of higher dividends, often have distinct tax implications and can result in higher or lower shareholders’ wealth. JEL Classification G32, G35, H24, H25