The effects of tax legislation have been even more indirect yet not less important. A major element has been the linkage of the corporate and individual income tax combined with the special treatment of capital gains under the individual income tax. Let us suppose a corporation earns an income of $1 million over and above corporate taxes. If it pays the whole million dollars to its stockholders as dividends, they must include it as part of their taxable income. Suppose they would, on the average, have to pay 50 per cent of this additional income as income tax. They would then have available only $500,000 to spend on consumption or to save and invest. If instead the corporation pays no cash dividends to its stockholders, it has the whole million dollars to invest internally. Such reinvestment will tend to raise the capital value of its stock. Stockholders who would have saved the funds if distributed can simply hold the stock and postpone all taxes until they sell the stock. They, as well as others who sell at an earlier date to realize income for consumption, will pay tax at capital gains rates, which are lower than rates on regular income.
This tax structure encourages retention of corporate earnings. Even if the return that can be earned internally is appreciably less than the return that the stockholder himself could earn by investing the funds externally, it may pay to invest internally because of the tax saving. This leads to a waste of capital, to its use for less productive rather than more productive purposes. It has been a major reason for the post-World-War-II tendency toward horizontal diversification as firms have sought outlets for their earnings. It is also a great source of strength for established corporations relative to new enterprises. The established corporations can be less productive than new enterprises, yet their stockholders have an incentive to invest in them rather than to have the income paid out so that they can invest it in new enterprises through the capital market.
— Milton Friedman - Capitalism and Freedom, p. 130