Academic journal article Financial Management

Managerial Response to the May 2003 Dividend Tax Cut

Academic journal article Financial Management

Managerial Response to the May 2003 Dividend Tax Cut

Article excerpt

We survey 328 financial executives to determine the effects of the May 2003 dividend tax cut. We find that the tax cut led to initiations and dividend increases at some firms. However, executives say that among the factors that affect dividend policy, the tax rate reduction is less important than the stability o f future cash flows, cash holdings, and the historic level of dividends. Tax effects have roughly the same importance as attracting institutional investors and the availability of profitable investments. We also find that press releases only occasionally mention the dividend tax cut as the reason for an initiation.


In May 2003, the dividend tax rate for retail investors fell dramatically. The top statutory tax rate on dividend income dropped from more than 38% to 15% and the top rate on capital gains declined from 20% to 15%. 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 evidence to explore how this large reduction in the tax cost of dividends affects corporate payout decisions.

Several recent empirical papers (described in Section V) 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 retail investors but not for taxable institutions, and retail investors are generally not thought to be of first-order importance.

To examine the relative importance of taxes on corporate payout decisions, we look at three types of evidence. First, in Section I, 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 Section III, 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 nontax 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 retail 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. …

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