 As with capital structure, taxes are also an important market imperfection that influences the firm's decision on distributing dividend as cash payment to the shareholders or in the form of repurchasing shares from these shareholders in the open capital market. Shareholders pay two types of taxes on their income. The first tax is the tax on their dividends and the second is the tax on their capital gains they earn in the capital market. If tax rate on dividend is greater than tax rate on capital gains, the shareholders will prefer to go for a repurchase transaction than to receive dividend in the form of cash. Also, a high tax rate on dividend prevents a firm to raise funds to pay shareholders as cash dividend. This means that in the firm, in the world of no taxes and issuance costs, if dividend is paid through the issuance of equity, then this means that the shareholders are not better off. This means what they are getting. In fact, they have already paid. This means that the amount they are receiving in the form of dividend is the amount they have paid to the firm in the form of proceed against the sale of issues. So in net, shareholders are getting nothing. But if the tax rate on dividend is greater than the tax rate on capital gains, shareholders will lose their initial investment that they had made in the firm's stock. To understand this, we have an example. The firm is raising new equity to the tune of $10 million and the firm is planning to pay this amount to the shareholders. So the total dividend in the form of cash is also equal to $10 million. Then the question arises that how much will shareholders receive if the tax is if dividend tax rate is 40% and capital tax rate gain tax rate is 15%. Now we see that the dividend receipt is equal to $10 million and there is a tax rate on this dividend by 40%. So the tax to be deducted from this receipt of $10 million is $4 million. Now as the firm is paying its 10 million cash to the shareholders, so there is declined by $10 million in the firm's overall value. This means that the capital gain of the shareholders will also be reduced by $10 million. So there will be a reduction in the capital gain tax paid by the shareholders to the tune of $1.5 million. Now in net, the shareholders are paying $2.5 million as a tax on this proceed of $10 million. But after making a payment of $2.5 million, the shareholders will be receiving a net proceed of $7.5 million. So there is a decline by $2.5 million in the income of the shareholders. So what would be the optimal dividend policy in the world of taxes? We have seen that if the tax rate on dividend is greater than the tax rate on capital gain, the shareholders will pay lower taxes in case of repurchase than the cash dividends. This means that this tax saving will also increase the firm value accordingly. And to equate investors of such firms, it is better that dividend paying firm needs to pay a higher amount of pre-tax return to the shareholders. And if the tax rate on dividend is greater than the tax rate on capital gain, the optimal dividend policy is simply that pay no dividend at all. Then if this is the policy, then why firms are paying cash dividend to the shareholders across the globe? This phenomena is now termed as a dividend puzzle in the corporate finance world. And that phenomena says the fact that the firms are continuing issuing dividends despite of this tax disadvantage.