Firms paying excess dividends may cause shareholders to pay taxes sooner and at a higher marginal tax rate than if the firm either held the excess funds,or found additional satisfactory investments.

Question

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When a firm pays excess dividends, shareholders may have to pay taxes on the income sooner and at a higher marginal tax rate than if the firm either retained the funds or invested in new projects. This is because dividends are typically taxed as income in the year they are received. Additionally, if the shareholders' income is already in a high tax bracket, receiving additional income in the form of dividends may push them into an even higher tax bracket, resulting in a higher marginal tax rate. Thus, paying excess dividends may not be the most tax-efficient way for a firm to distribute its earnings.

Firms Paying Excess Dividends May Cause Shareholders to Pay Taxes