by Richard W. Kopcke
No. 3, January 2005 - June 2005

Motivation for the Research
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) essentially halved the tax rate on dividends and reduced the top tax rate on capital gains, so that dividends and longterm gains are now taxed at about one-half the rates on short-term gains. This paper explores the likely effect of JGTRRA on the valuation of corporations’ common stock.

Research Approach
Looking at data for companies that have been included in the S&P 500 index at any time during the last 20 years, the author analyzes the dividend policy of each corporation. Only 28 of these companies had reduced dividends as a share of earnings and reduced their outstanding shares through repurchases before JGTRRA.

He also examines companies’ incentives for retaining earnings, purchasing their own shares, and distributing earnings as dividends, by extending the Gordon model of stock prices to include the effect of taxes on the cost of capital and the value of equity. He applies this analysis of the cost of capital to companies’ demand for capital assets to assess the likely macroeconomic effect of the tax changes of 2003.

Key Findings

• Both larger corporations’ past behavior and theory suggest that the tax cuts are not likely to increase dividend payouts significantly.
  
  
• Instead, in the short run, dividends will continue to rise in the customary way in response to the recovery in earnings.
  
  
• In the longer run, the tax cuts will principally reduce companies’ cost of capital, fostering capital deepening, when the economy is at full employment.
  
  
• This capital deepening reduces the return on capital, which in turn encourages companies to retain a larger share of earnings to fund their capital budgets.
  
  
• Because the tax cuts increase the value of each dollar of earnings for shareholders, they could raise price-earnings ratios by more than 10 percent, and stock prices by more than 6 percent.
  
  
• By fostering capital deepening, the tax cuts also tend to increase the real compensation of labor at full employment.

Implications
As a result of the tax cuts on dividends and capital gains, both average real returns on equity and dividend yields need not be as high as they were during much of the last half century in order to attract capital. Unless the economy’s potential rate of growth or rate of inflation is significantly higher than current estimates, about 3.5 percent and 2.5 percent, respectively, the composition of returns on equity will shift toward dividends once again, albeit not as strongly as before 1994.

Full text of Public Policy Discussion Paper 05-1