Andrew Foerster

English

Research Papers in Economics

O
n May 28, 2003, President Bush signed the second major
tax cut of his presidency, a $350 billion plan that has a
number of provisions:
• Increasing the child tax credit from $600 to $1000;
• Lowering marginal income tax rates;
• Eliminating the “marriage penalty”; and
• Lowering the capital gains and dividend tax rates.
The dividend tax cut lowers the rate to either 15 or 5
percent, depending on income, and is set to expire in 2008.
It will have to be extended or made permanent to continue
beyond that date. What will be the likely effects of the div-
idend tax cut?
Companies probably will start
paying out more dividends. According
to Austan Goolsbee, an economist at
the University of Chicago, “numerous
firms that were on the margin of
retaining earnings for capital gains or
paying them out as dividends are going
to lean towards paying them out as
dividends.” This change may increase
the number of people looking to invest
in those firms. “We’re going to see a
smaller, but still somewhat noticeable,
shift in the composition of portfolios
towards dividend-paying stocks,” says
Goolsbee.
Paying investors dividends may lead
to more efficient capital markets, as investors move money
between companies and put it to its most profitable use. “By
encouraging more dividend payout … dividend recipients can
buy stock in other companies or buy bonds issued by other
companies, and move that capital around,” says Martin Feld-
stein, president of the National Bureau of Economic
Research and an economist at Harvard University.
The price of capital should also decrease. The bill “will
lead to a reduction in the cost of capital for those corpora-
tions that are … planning to pay dividends over the next few
years, and that would increase investment somewhat,” says
Joel Slemrod, an economist at the University of Michigan.
The new tax change also reduces the appeal of debt to
equity. Firms can deduct their interest payments on debts,
but the payout of dividends is taxed, making equity less
appealing. The new law reduces that gap. “The law as it was
before the change encouraged companies to have more debt
and to take the extra risks that go with higher leverage,” says
Feldstein. “And by reducing the burden on returns to equity
the new tax law reduces the incentive to take that extra risk
by using more debt.”
Indeed, a few large corporations announced changes in their
dividend policy after the tax change. Citigroup Inc. announced
a 75 percent increase in dividend payouts, from $0.80 to $1.40
per share. Citigroup Chairman and CEO Sanford Weill cited
the tax law as a main reason for the change.  “The recent
change in the tax law levels the playing field between dividends
and share repurchases as a means to return capital to share-
holders,” he said. Numerous other firms, including Walgreen
Co., Proctor & Gamble Co., and The Goldman Sachs Group
Inc., also have increased their dividend payout.
This bill should increase asset values, says Alan Auerbach,
an economist at the University of Cal-
ifornia at Berkeley. Lower- and middle-
income people may be helped
indirectly by this, but “the [main]
impact is really going to be at higher
income levels where people are actu-
ally holding these assets directly in
taxable accounts rather than tax-shel-
tered savings.”
Feldstein says that the lower rates
may also encourage people to put addi-
tional money into investments. “To the
extent that [lower- and middle-income
households] have 401(k) or IRA
income, it may actually encourage
them to hold equities directly, rather
than in the form of 401(k)s or IRAs,
because the tax burden has been reduced so much.”
The biggest argument against this latest round of tax cuts
was that it would reduce government revenues. “Even if these
tax cuts do make the economy stronger, I think it’s very
unlikely that it will increase the tax base so much to offset
these tax cuts,” Slemrod says. Feldstein agrees, but says the
effects will not be “as large as the so-called ‘static analysis’
used by the government suggests.”
Advocates of limited government often view tax cuts as a
useful way to restrain government spending, since they typi-
cally reduce revenue growth. Feldstein, for instance, notes that
future governments may have to respond “by taking a harder
look at some of the spending and tax subsidies that we have
in the tax law today.” Auerbach agrees. But he is less sanguine
about that possibility. “If you do assume [the tax cuts] are per-
manent, then there are pretty enormous costs in the decades
to come, and we’re already in a situation where we don’t have
enough money to pay for Social Security and Medicare.”
Unfortunately, economics does not provide any easy
answers to this debate. It merely illuminates the multiple
viewpoints people can take. RF
BY ANDREW FOERSTER
LEGISLATIVEUPDATE
Dividend Tax Cuts
Fall 2003 • Region Focus 5
From Six Brackets to Two
Single Joint Old New
Filers’ Filers’ Dividend Dividend
Income Income Rate* (%) Rate (%)
$7,000 $14,000 10.0 5.0
$28,400 $56,800 15.0 5.0
$68,800 $114,650 27.0 15.0
$143,500 $174,711 30.0 15.0
$311,950 $311,950 35.0 15.0
>$311,950 >$311,950 38.6 15.0
*Dividends were taxed at the same rate as income prior
to the recent change.
SOURCE: Internal Revenue Service

Legislative update : Dividend tax cuts

http://www.richmondfed.org/publications/research/region_focus/2003/fall/pdf/legislative_update.pdf

Legislative update : Dividend tax cuts

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