The extant literature has shown that dividends have positive valuation implications due to signaling and agency cost effects. However, under the tax systems of most countries, individual investors face a higher tax rate on dividend income than on capital gains. Therefore, individual investors pay a dividend tax penalty, which results in lower equity values. U.S Studies indicate that as the level of institutional ownership increases, the likelihood that a marginal investor is not a high-tax-rate individual increases. Consequently, the negative dividend tax penalty effect on the positive market response to dividend surprises should decrease. This study extends previous research to investigate the tax effect of dividends under Taiwan's imputation tax system. We find that dividend tax penalty partially offsets the positive effects of dividends on equity values. However, this negative tax effect of dividends can be alleviated by the presence of a marginal investor who represents a tax-exempt institution.
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