Academic journal article Financial Management

How Did the 2003 Dividend Tax Cut Affect Stock Prices?

Academic journal article Financial Management

How Did the 2003 Dividend Tax Cut Affect Stock Prices?

Article excerpt

We test the hypothesis that the 2003 dividend tax cut boosted US stock prices and thereby lowered the cost of equity capital. Using an event-study methodology, we attempt to identify an aggregate stock market effect by comparing the behavior of US common stock prices with that of foreign equities and the equities of real estate investment trusts (REITs). We also examine the relative cross-sectional response of prices of high- and low-dividend-paying stocks. We do not find any imprint of the dividend tax cut news on the value of the aggregate US stock market. On the other hand, high-dividend stocks outperformed low-dividend stocks by a few percentage points over the event windows, suggesting that the tax cut may have induced asset reallocation within equity portfolios. Finally, the positive abnormal return on nondividend paying US stocks in 2003 does not appear to be tied to tax cut news.


On May 28, 2003, President George W. Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003 that, among other provisions, reduced the maximum tax rate on dividends from 38% to 15%. A related provision in the bill lowered the top rate on long-term capital gains from 20% to 15%, thereby equalizing those two tax rates for the first time since 1990. The dividend tax cut was perhaps the most dramatic provision in the bill and was almost certainly the most contentious. Indeed, the bill passed the Senate on a vote of 51 to 50, following weeks of wrangling. Up until the very end it remained unclear whether the bill would contain anything close to the significant cut in dividend taxes that was ultimately enacted.

During the debate leading up to enactment, proponents of the bill ascribed many benefits to the dividend tax cut. One of the main arguments was that reducing taxes on investment income would lower the cost of capital to business, stimulating investment and job creation. (1) In turn, higher US corporate equity prices would also boost spending through the wealth effect. (2) For instance, a Treasury official testified before Congress that, although the Treasury had not worked up its own estimate, "estimates [by others] of the impact on stock market valuations range from 5 percent to 15 percent" (Fisher, 2003). By capitalizing the CBO projection of the annual flow of foregone dividend taxes, Poterba (2004) estimated that the dividend tax cut could have boosted the value of US equities by roughly 6%. The likely valuation effects remain a relevant concern going forward, when Congress faces the decision of whether to allow the tax cuts to expire in 2010, as provided for in current law.

In this paper, we test the hypothesis that the cut in capital taxation boosted US stock prices. (3) We use an event-study methodology focused on time periods with notable positive news about the potential for passage of a dividend tax cut. We attempt to identify an aggregate market effect by comparing the behavior of US common stock prices with the prices of securities that received no direct benefit from the tax cut. Our primary test involves comparing stock returns in the United States with returns on foreign stock markets, where US investors--the beneficiaries of the tax law change--hold only a small fraction of shares and so are presumed to have little weight in the "marginal investor." We also compare the performance of US stocks with the returns of real estate investment trusts (REITs), which received no benefit from the tax cut as they were already tax advantaged.

In addition, we analyze the cross-sectional impact of the dividend tax cut news, by examining the relative response of stock prices across firms with different dividend policies. Such analysis allows us to address the tax effect at a disaggregated level and provides a check on the validity of our event window choices. Given the uncertainty that always surrounds future tax policy, compounded in this case by sunset provisions and projections of large budget deficits, investors may well have discounted the tax savings on far-future dividends more heavily. …

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