NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Taxation and Corporate Payout Policy

"The recent tax legislation (JGTRRA) ultimately will increase dividends by almost 20 percent."

The Job Growth and Taxpayer Relief Reconciliation Act of 2003 (JGTRRA) substantially reduced the individual income tax on dividends. It also reduced tax rates on capital gains from the sale of corporate stock. Before JGTRRA, an individual investor in the top federal income tax bracket received after-tax dividends equal to 61.5 percent of his pre-tax dividends. After-tax capital gains, by comparison, were at least 80 percent of pre-tax gains. Proponents of tax relief argued that lowering the dividend tax would raise corporate payout by reducing the cost of paying dividends, and that it would reduce the corporate cost of capital, thereby encouraging investment.

In Taxation and Corporate Payout Policy (NBER Working Paper No. 10321), author James Poterba analyzes the potential impact of JGTRRA on corporate payout behavior by examining the historical relationship between the relative tax burden on dividends and capital gains and the share of corporate earnings distributed as cash dividends. He also considers actual changes in payout behavior since JGTRRA was enacted and discusses the interaction between payout decisions and investment decisions. Poterba finds that the enactment of JGTRRA raises the after-tax value of dividends relative to capital gains by more than 5 percentage points. Based on historical patterns of corporate behavior, he predicts that JGTRRA ultimately will increase dividends by almost 20 percent.

Media accounts of corporate dividend policy in the months since passage of JGTRRA have emphasized the decisions by several large firms, such as Microsoft, to initiate or increase dividends. Other researchers have reported that dividend payments did increase in the quarter after JGTRRA was enacted. During 2003, the net increase in dividends paid by firms in the Standard and Poors' 500 -- defined as the percentage of firms increasing dividends minus the percentage of firms reducing dividends -- was 38.7 percent. This contrasts with 29.8 percent in 2002 and 30.2 percent in 2001. However, it is difficult to draw any conclusions from these numbers because the percentage of firms raising their net dividends in 2001 and 2002 was substantially lower than the comparable percentage throughout most of the previous two decades.

Poterba suggests that by reducing the tax burden on future dividends, JGTRRA also should increase stock prices. The U.S. Congressional Budget Office (2004) estimates that the dividend and capital gains tax provisions of JGTRRA will reduce federal income tax revenues by $23 billion in 2004 and by larger amounts in future years. This revenue stream can be capitalized to determine its impact on stock prices. In the first half of 2003, the price-earnings ration on the S&P500 was close to thirty. If the stock market capitalized the dividend tax cut in the same way that it capitalized other earnings, the implied increase in stock market value would be approximately $690 billion, or roughly 6 percent of the $11.4 trillion aggregate value of U.S. equities at the end of March 2003.

-- Les Picker


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