TCS Daily

'A More Attractive Choice'

By Aswath Damodaran - April 25, 2003 12:00 AM

For decades, individual investors in the United States have had to pay taxes on dividends that they receive, which in turn were paid out by corporations from after-tax income. The double taxation of dividends - once at the hands of the corporation and once in the hands of investors - contrasts with the treatment of interest expenses, which are fully deductible to corporations.

On January 8, 2003, President Bush proposed a dramatic change in the tax laws when he suggested that dividends be made tax exempt to the investors who receive them. The dividend tax exemption would be available only to investors in companies that pay taxes in the first place, ensuring all profits are taxed at least once. Companies that choose not to pay out dividends currently (i.e. reinvest their profits) would create a provision for future nontaxable dividends. This provision for previously taxed yet undistributed profits would increase the investors' stock basis (thus reducing capital gains taxes). Not surprisingly, if the Bush plan becomes law, equity prices should increase to reflect higher after-tax returns to investors.

Dividends and Equity Valuation

The dividend tax cut will very likely reduce the risk premium charged by investors for buying stocks. Equity risk premiums reflect the risk aversion of investors (e.g. risk premiums go up in periods of economic uncertainty) and the perceived risk of equity as an investment class. For example, the accounting scandals of the last few years have also increased premiums.

Why would the equity risk premium be affected by the taxation of dividends? The equity risk premium measures how much more on a pre-tax basis investors demand from their equity investments than from a risk-free investment. To the extent that investors are taxed on the income that they make on their equity investments, they will have to demand a higher pre-tax return. Consider how changing the tax rate will affect equity risk premiums today. The Treasury bond rate in early 2003 was 4% and the pre-tax equity risk premium on January 1, 2003, was 4.1%. Thus, the pre-tax expected return on equities was 8.1% (4% risk-free rate plus 4.1% equity risk premium). The dividend yield on US stocks in early 2003 was roughly 2% and the average tax rate paid by investors in the market on ordinary income was roughly 21% and the capital gains was 15% . With these tax rates, the after-tax expected equity return is 6.785%. If dividends were to become tax exempt, investors could earn the same after-tax return of 6.785% with a lower pre-tax return of 7.61%, translating into a drop in the equity risk premium from 4.1% to 3.61%. Holding the dividend yield constant, look at the valuation of the S&P 500 using both the 4.1% implied premium and the 3.61% premium:

  • Value of S&P 500 with an implied premium of 4.1% = 879.82 (on January 1, 2003)

  • Value of S&P 500 with an implied premium of 3.61% = 1003.02

If these calculations hold up, the change in tax rates would translate into an increase in the level of the index of roughly 14%. This is probably a conservative estimate, since companies are likely to increase or even initiate dividends in response to the tax law change (thus increasing the dividend yield). In addition, higher tax rate individuals are likely to shift their portfolios to include more high-dividend paying stocks, thus raising the average tax rate for investors.

While the above calculations were done for the entire S&P 500, investors can compute the implied risk premium on a company-by-company basis to determine the likely impact of dividend tax cuts on individual stock values. The effect will be larger for stocks that pay high dividends.

Dividends and Corporate Finance

Corporate finance has three components: investment policy, where you decide what investments to make (whether to invest in particular projects); financing policy, where you determine the mix of debt and equity (how to raise the capital for each project); and dividend policy, where you evaluate how much and how to return cash to stockholders.

If dividends become tax-exempt to investors, investment policy will be affected in two ways. As we noted earlier, reducing taxes paid on dividends will reduce the equity risk premium and the cost of equity. This, in turn, will reduce the cost of capital and potentially make projects that were unattractive before the tax law change into at least marginally attractive investments. Since the change in the cost of capital is likely to be small (0.5% to 1%), the effect will be small. More significantly, the pattern of earnings and cash flows on projects may play a role in whether firms invest in them in the first place. Since only firms that pay taxes on their income will be eligible for tax-exempt dividends, companies may choose not to invest in projects that have large and negative effects on corporate earnings in the earlier years even if they pass the "good project" test (i.e. earn expected returns in excess of the "hurdle rate").

Financing policy will be affected more profoundly. The drop in the equity risk premium will make equity more attractive to companies raising funds relative to debt. On the other side of the ledger, the new tax law will introduce a potent new cost to debt. In addition to the bankruptcy and agency costs that come with borrowing more money, too much debt can also create a potential lost tax benefit to investors in the company. This is because the dividend tax exemption is available only to firms that pay taxes, and the taxable income is more likely to be negative when a firm has substantial interest payments. The net effect of reducing the benefits to using debt and increasing the potential cost will be lower optimal debt ratios for all firms, though the effect will vary across firms. The magnitude of the change will depend upon the change in cost of equity. The greater the drop in the equity risk premium, the more pronounced will be the shift to equity. Financing decisions will also depend on the specific characteristics of the firm. Those with more volatile operating earnings will be less likely to put the dividend tax exemption at risk by borrowing money in the first place.

In the last two decades, firms have increasingly shifted from paying dividends to buying back stock. Dividend tax relief will significantly alter the tradeoff. If dividends are tax exempt to investors, yet repurchased shares remain subject to capital gains taxes, dividends will have a tax advantage over capital gains . Therefore, firms should increasingly shift back towards dividend payments accompanied by a shift to a policy of residual dividends, where dividends paid are a function of current earnings. from a policy of sticky dividends, in which historical dividends set the precedent for current distributions.

Macro Effects

Will this tax law provide a stimulus to the economy? In the short term, it is difficult to see how a lower cost of equity and smaller risk premiums will translate into higher capital investments by companies. In the long term, there will undoubtedly be consequences for the economy, many positive and some potentially negative. The decline in corporate debt and the increasing use of equity will be positive news for the economy. Note that the tax benefits of debt are ultimately borne by other taxpayers in the economy, and a shift to equity will require projects to be justified based upon their true returns and not as much on the tax benefits created by debt. Furthermore, when firms become financially distressed, the costs are substantial not only for employees, customers and investors in the firms, but also for society. A shift towards equity in funding will reduce both the number of firms in distress and the likelihood of distress for all firms. As a side benefit, increasing the incentives to pay dividends, the tax law will reduce the cash held and the investments made by the least efficient firms in the market. The cash paid out as dividends can be redirected by investors to firms with better investment prospects.

There are two potential negative consequences. First, if the desire to pay dividends causes firms to shift funds from good investments to dividends, these firms and society will pay a price in the form of less real investment and lower growth. Second, the shifting of funds towards equity from the corporate bond and treasury bond market can cause increases in interest rates that overwhelm the decline in the equity risk premium.

In summary, the argument that changing the tax treatment of dividends will correct distortions created by a century of preferred tax treatment for debt is much stronger than the argument that the tax law change will be a short term stimulus to the economy. Of course, an increase in equity markets of the magnitude that we estimated in the valuation section - about 14% - will be a powerful boost to both investor and consumer spirits in a market where investors have lost so much faith in equities over the last few years.

The author is Professor of Finance, Stern School of Business. A longer paper on the same topic can be found here.


1. About 30% of stocks are held by pension funds and are not taxed. The remaining 70% are held by mutual funds and individual investors. These investors tend to be wealthier and we are assuming an average tax rate of 30% for these investors.

1. This may be partially alleviated by the proposal to allow investor to increase the book value of their equity holdings if companies set aside money for future investments, thus reducing their eventual capital gains taxes. Without an inflation adjustment, this will provide only partial protection for capital gains.

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