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The effect of the May 2003 dividend tax cut on corporate dividend policy: empirical and survey evidence.

Article Excerpt
INTRODUCTION

In December 2002, the Bush administration floated a radical proposal to reduce the taxation on dividends to zero. The official motive behind the proposal was to give the economy a boost by increasing investors' disposable income. Andrews (2003) quotes R. Glenn Hubbard, Bush's economic adviser at the time, as stating that reducing dividend taxation could boost overall stock prices by 20 percent, increasing spending and consequently economic growth. Moreover, many argue that the dividend taxation should be eliminated for the simple reason that dividends are taxed twice: Once at the corporate level since companies pay dividends from after-tax earnings, and then again at the level of the investor, who must pay income tax on dividends received. Interest income on the other hand, is taxed only at the investor level (because debt interest is paid from before-tax corporate income). This disparity between dividends and interest taxation creates a tax advantage to debt financing. Proponents of the proposal, therefore, argue that reduction in dividend taxation will reduce the corporate bias towards using debt financing. Finally, it is argued that the reduction in dividend taxation will reduce the cost of capital and increase investment, providing another boost to economic growth.

Since the majority of dividends are received by very wealthy individuals, opponents of the proposal argue that the elimination of dividend taxation is a tax break to the rich, which they claim makes this proposal unfair and ineffective: unfair because the tax reduction will disproportionally benefit the rich and increase the income disparity in the US, and ineffective because the marginal propensity to consume among those wealthy individuals is rather low and, thus, a very significant portion of dividends will not be consumed but will instead be saved. Moreover, the estimated cost of the proposal is more than $300 billion over the first ten years of implementation. Finally some economists argue that the reduction in dividend taxation will increase the amount of dividends paid by corporations and will reduce corporate investment and, therefore, it might have a counter-productive impact on the economy (Auerbach, 1979).

After a period of negotiations between the White House, Senate and House, a modified version of the original proposal went into effect in May 2003. The dividend tax rate for individual investors fell dramatically but was not eliminated. The top statutory tax rate on dividend income dropped from more than 38 percent to 15 percent and the top rate on capital gains declined from 20 percent to 15 percent. According to theory, this tax cut should have led to greater dividend payout because it reduced the tax disadvantage of dividends relative to capital gains. (Capital gains are still somewhat tax-favored because they can be delayed until the investor sells the stock or avoided altogether at death.) In this paper, we use survey and other empirical evidence to explore how this large reduction in the tax cost of dividends affects corporate payout decisions.

Several recent empirical papers (described in the fifth section) argue that the May 2003 tax reduction led to increased dividend payments. We do not dispute this conclusion. Rather, we examine whether the tax reduction affected payout policy in a first-order or second-order manner. In the latter case, we could imagine that some firms were "on the fence" about paying a dividend, given the existing equilibrium. The tax cut might have led these firms to initiate dividends but, overall, the effects of the tax effect might still have been modest. It seems plausible that the tax effect was second-order because the May 2003 tax cut reduced tax rates for individual investors but not for taxable institutions, and individual investors are generally not thought to be of first-order importance.

To examine the relative importance of taxes to corporate payout decisions, we look at three types of evidence. In the first section we present summary information on dividend initiations and aggregate payout. This evidence indicates that there was a surge in initiations that peaked in the quarter after the tax cut and then returned to pre-cut levels. Moreover, the average age of an initiator also fell in the year after the tax cut, but has since returned to historic levels. We also find that aggregate repurchases have grown much more than aggregate dividends since May 2003. Taken together, these results are not consistent with the tax cut having had a long-lasting, first-order impact. If anything, the evidence is more consistent with a spike in dividend activity.

Second, in the third section we survey corporate decision-makers and ask them directly whether reduced dividend taxation caused their firms to initiate or increase dividends, and if so, how important the tax effect was. We also examine the relative importance of several non-tax factors. The surveyed executives indicate that investor tax rates affect corporate dividend decisions. We also find weak evidence of a differential effect of tax rates on firms for whom individual investors are most important. This finding is consistent with the theoretical tax prediction. However, the executives indicate that tax rates are a second-order concern, less important than several other factors.

One in 11 firms in our survey sample had initiated dividends during the previous three years, and these firms report that on average, the dividend tax cut had a small to moderate effect on their initiation decision. Among initiators, the long-term stability of cash flows and cash position of the firm are more important than tax considerations, and the reduced availability of profitable investments and the desire to attract institutional investors are on par with taxes. More than 40 percent of the firms in our sample have continuously paid dividends over the past several years. These dividend-payers report that the historic level of the dividend is more important than are tax considerations, as are the stability of...

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