First, all publicly traded
companies with a home office in Maine were pulled from the
database, providing a sample of 18 corporations. Next, based on
several key data items during the period of 1997 to 2001, any firm
missing data items for more than two years was excluded,
paring the sample from 18 to 12 companies.
The weights for the WACC,
wd and ws, were calculated
by averaging the companies' total-debt-to-asset and
total-common-equity-to-asset ratios, respectively, from 1997 to
2001. The cost of debt, kd, was estimated by
averaging the firms' interest-expense-to-debt ratio from 1997 to
2001. When a company's interest-expense-to-debt ratio was not
reported, an average of the 3-Month AA Financial Commercial Paper
rate from June 2001 through March 2003, as published by the Federal
Reserve, was used instead.
The average marginal corporate
tax rate was estimated using, where available, the average (from
1997 to 2001) ratio of the firm's cash paid in taxes to net
operating cash flow. When these data were unavailable, a corporate
tax rate of 35 percent was used. This method resulted in a
mean average marginal tax rate for the 12-firm sample of 38 percent
and a median rate of 35 percent. Since the corporate tax rate is
used only for the debt component of the WACC-a component which does
not change under the Bush proposal-the difference between the
current-law WACC and the post-Bush plan WACC is unaffected by this
To estimate the dividend component, D1, of the
cost of equity capital, ks, an average dividend
was calculated using the mean cash dividend paid during the
period 1997 to 2001. The purchase price of the stock,
P0, was estimated as the 1997 average quarterly
price and was calculated by dividing the firms' quarterly market
value by its quarterly number of common shares outstanding.
The equity growth rate, g, was estimated as the mean of the
monthly Moody's Seasoned Aaa Corporate Bond Yield as published by
the Federal Reserve.
Both the statutory personal
tax rate for debtholders, td, and the
statutory personal tax rate on dividends, tdiv,
were assumed to be 27 percent. The effective personal tax rate on
capital gains, teffcg, was estimated as
where tscg is the statutory tax rate on
capital gains, P1 is the 2001 average share
price, and P0 is the 1997 average share price.
The statutory tax rate on capital gains, tscg,
was assumed to be 20 percent. The 2001 share price,
P1, was calculated in the same manner as the 1997
average share price (see above). To estimate the cost of equity
capital, ks, under the Bush plan, the excludable
distribution amount (EDA) was estimated for each
The amount of the EDA
determines the amount of cash that can be distributed to
shareholders as dividends that can be excluded from their adjusted
gross income. The amount of the EDA also determines the amount
of retained cash that can be used to provide shareholders with a
basis adjustment. (Any amount of cash less than or equal to
the EDA that is retained in the firm can be used to provide a basis
adjustment.) Based on proposed U.S. Treasury rules, all companies
would assume a corporate tax rate of 35 percent and would
calculate their EDA as follows:
EDA = (U.S. income taxes
- U.S. income taxes
where U.S. income taxes paid
the prior year are used to calculate the EDA for the current
To estimate the EDA for the 12
companies in the sample, income tax expense as reported on the
income statement was used as an estimate for U.S. income taxes. The amount of the excludable
dividend was then estimated as the EDA divided by the average
number of common shares outstanding for the given year. The
average number of shares outstanding was estimated by averaging the
number of shares outstanding for each fiscal quarter. The
basis adjustment was then estimated by subtracting the per-share
excludable cash dividend from the per-share EDA (the EDA divided by
the average number of shares outstanding).
Using these EDA calculations,
the cost of equity capital, ks, was estimated for
all the companies in the sample. For those dividend-paying
companies distributing less than their EDA, the term
[ws(D1 * tdiv/P0
+ g * teffcg)] in the WACC equation simplifies to
[ws(g * teffcg)], signifying the Bush
plan's personal dividend exclusion. For
non-dividend-paying firms, as well as those firms with an EDA
greater than their cash dividends paid, the cost of equity capital
was lowered to reflect a basis adjustment.
The basis adjustment is
estimated as the EDA, less total cash dividends paid, divided by
the number of shares outstanding for a given fiscal year.
Under the Bush proposal, the annual basis adjustment can be
carried over to subsequent years. This cumulative total, or
Cumulative Retained Earnings Basis Adjustment (CREBA), can be added
to the basis of a stock when it is sold, thus lowering the
effective capital gains tax rate.
To estimate the effect of the
basis adjustment, the effective tax rate on capital gains,
teffcg = tscg(P1 -
P0)/P0, was calculated by adding the
per-share CREBA to the purchase price of the stock,
P0. All investors were assumed to buy their
shares in 1997 and hold them through the end of 2001.
Dividend Tax Rates
We used Heritage's Individual
Income Tax Micro-Simulation Model to estimate the effective
personal dividend tax rates for childless married- joint filer
taxpayers in the first five income tax brackets (the current-law
tax brackets for 2003). The results highlighted in this CDA
Report are the effective dividend tax rates for married couples
with taxable income near the midpoint of the first five brackets. To estimate the effective
personal tax rates, an average corporate income tax rate was
estimated using Standard and Poor's (S&P) Compustat
A sample of approximately
5,300 firms was screened on the basis of all active companies in
the database with the data item TXPD, which represents "cash
payments for income taxes to federal, state, local, and
foreign governments as reported by a company that has adopted
FASB #95." The tax rate was then
estimated by taking the ratio of TXPD to the firms' net
operating cash flow, S&P data item OANCF. This
measure was calculated for each fiscal year from 1990 through
2001. (See Table 5.) Since the average ratio for the 11-year period
was 24.75 percent, an estimated corporate tax rate of 25
percent was used to calculate the effective personal tax
The total dividends received
by taxpayers, D, was grossed up to a pre-corporate tax
amount by dividing the dividends received by the complement of
the estimated corporate tax rate (D/1 - 0.25). The amount of
the corporate tax paid on the dividends was then calculated as the
corporate tax rate (0.25) multiplied by the pre-tax corporate
dividend (D/1 - 0.25).
The personal tax on dividend income was calculated by multiplying
D by the statutory tax rate corresponding to the taxpayer's
taxable income. The effective personal tax rate on dividends was
then calculated by dividing the combined tax (corporate plus
personal) on the dividend income by the pre-tax corporate
dividend (D/1 - 0.25).
These levels of
income are approximately equal to the taxable income midpoints of
the respective tax brackets and assume a corporate tax rate of 25
providing shareholders with a basis adjustment for retained funds,
the personal dividend exclusion component of the President's plan
has garnered most of the media attention. From an economic
standpoint, however, the basis adjustment, which lowers
shareholders' effective capital gains tax rates, is also important.
Combined, the two components eliminate distortions from having
various tax rate structures for corporate income while also
eliminating a major source of double taxation.
For more on the
hurdle rate, see Norbert J. Michel, "Everyone Profits from Hurdling
Dividends," Heritage Foundation Web Memo No. 248, April 3, 2003, at
According to a
1993 study of Fortune 500 companies by Howard Bierman, 93 percent
of these companies calculate a WACC as part of their capital
budgeting process. See Eugene F. Brigham and Joel F. Houston,
Fundamentals of Financial Management (Fort Worth, Tex.: The Dryden
Press, 1999), 2nd ed., p. 394.
specified here, a more general version of this equation could
include the weight and cost of preferred equity and other financing
instruments as well.
tax rate is applied only to the debt rate and only because interest
is tax-deductible at the corporate level (providing a tax subsidy
to debt), while equity payouts are not.
taxed as ordinary income while most capital gains are taxed at
either 10 percent or 20 percent, depending on an individual's
for a stock's expected return is known as the "constant growth" or
Gordon model. The assumption is that both dividends and equity will
grow at constant rates for the period in question. See Brigham and
Houston, Fundamentals of Financial Management, and Stephen Ross, R.
Westerfield, and Jeffrey Jaffe, Corporate Finance (Boston:
Irwin/McGraw- Hill, 1999).
sample of 12 firms represented 61.26 percent of the full sample's
(18 firms) total asset value and 90.82 percent of the full sample's
reported market value. (Market value was not reported in the
Compustat database for three companies in the full sample. For
details, see the Appendix.) See Table 4.
Economy-wide estimates of the user cost
of capital using the method developed by Alan Auerbach predict that
the President's plan would lower the cost of capital by about
5.6 percent. For the Auerbach method, see Alan J. Auerbach,
"Taxation, Corporate Financial Policy and the Cost of
Capital," Journal of Economic Literature, Vol. 21, Issue 3
(September 1983), pp. 905-940. For the methodology used for the
WACC estimates in this paper, see the Appendix.
effective tax rate is the combined rate of tax, both corporate and
personal, that the taxpayer pays on dividends. For details on how
the corporate tax rate and effective rates were estimated, see the
"basis" refers to the purchase price of the stock. For example,
when investors calculate their capital gains tax liability,
they subtract the purchase price of their stock from the selling
price. Providing a basis adjustment means that, for tax purposes,
investors can increase their purchase price (the basis), thus
lowering their effective capital gains tax.
At the end
of its FY 2002, Idexx Labs, Inc., had a market value of roughly
$1.17 billion, net sales of about $413 million, and total assets of
approximately $417 million. At the end of its FY 2001, Idexx had
more than 2,000 employees. (This figure was not reported in
the Compustat database for 2002.)
complete details on the methodology, see the Appendix.
on the mechanics of the basis adjustment, see the Appendix.
includes all firms in the Standard and Poor's (S&P) Compustat
database for which the measures IOTSHR0 (percentage of shares held
by institutions), CSHO (common shares outstanding), and CEQ (common
equity) are reported (about 70 percent of all the firms). See
Norbert J. Michel, "Most Stocks Are Held by Private Investors,"
Heritage Foundation Web Memo No. 265, April 18, 2003, at www.heritage.org/Research/Taxes/wm265.cfm.
Weisman, "White House Eases Stand on Dividend Tax," The Washington
Post, April 22, 2003, p. E1.
also projects that implementing the plan would maintain an
off-budget surplus throughout the 10-year window. See William W.
Beach, Ralph A. Rector, Alfredo Goyburu, and Norbert J. Michel,
"The Economic and Fiscal Effects of the President's Growth
Package," Heritage Foundation Center for Data Analysis Report No.
03-05, April 16, 2003, at www.heritage.org/Research/Budget/cda03_05.cfm.
As long as
the managers act in the best interest of their shareholders, this
relationship holds for all firms with existing equity capital that
either pay or have the potential to pay dividends.
together, D1 * tdiv/P0 represents the effective personal tax rate
on the dividend yield. The calculation for estimating the effective
personal tax rate on capital gains is explained below.
Standard and Poor's Compustat (North America) Database is published
by McGraw-Hill Companies, Inc, and contains financial data on
over 10,000 publicly traded United States corporations. For more
than 35 years, S&P Compustat data have been recognized as one
of the financial information industry's leading resources for
in-depth financial information on publicly traded companies.
Compustat (North America) data are collected and standardized
according to detailed guidelines aligned with the regulations and
standards of the Financial Accounting Standards Board (FASB),
Securities and Exchange Commission (SEC), and U.S. Generally
Accepted Accounting Principles and Procedures (GAAP).
commercial paper rate was used for four companies because their
interest expense was not reported in the Compustat database. Since
the difference between debt components for the current-law WACC and
the WACC under the Bush proposal would be zero, these
assumptions do not affect the overall change in the companies'
WACC. To access the commercial paper rate series, see Federal
Reserve at research.stlouisfed.org/fred/data/irates/cpf3m.
a minimum long-term growth rate for all firms, the average of the
Moody's Seasoned Aaa Corporate Bond Yield was taken from 1919
through 2003. While S&P does provide an equity growth rate for
companies in its database, the mnemonic for which is EQGROW, this
measurement was available only for a small number of the firms in
the sample. To access the corporate bond yield series, see Federal
Reserve at research.stlouisfed.org/fred/data/irates/aaa.
to U.S. Treasury documents, all firms calculating their EDA will
use a corporate tax rate of 35 percent. For more on the mechanics
of the EDA, see U.S. Department of the Treasury, "Fact Sheet:
Ending the Double Tax on Corporate Earnings," January 14,
2003, at www.treas.gov/press/releases/kd3761.htm.
companies in the sample with zero, negative, or a missing value for
income tax expense, the EDA was assumed to be zero. Cash used to
pay taxes was not used to calculate the EDA because the measure was
not available for all years for all the firms in the sample.
However, as a sensitivity test, EDA was calculated for those firms
with the item "TXPD" (cash paid in taxes) reported in Compustat. In
some cases, the amount of the EDA was higher using the cash paid in
taxes rather than using the income tax expense.
to proposed rules, "the sum of excludable dividends and basis
increases cannot exceed the lesser of EDA or current and
accumulated earnings and profits. If the corporation's earnings and
profits is less than EDA, then basis increases are limited to the
excess of earnings and profits over excludable dividends." Also, if
a corporation's EDA is less than its cash distributions, these
excess distributions offset prior years' CREBA. This situation did
not occur for any of the firms in the sample. For more on the
proposed rules, see U.S. Department of the Treasury at www.ustreas.gov.
analysts examined married-joint filer taxpayers with adjusted gross
income ranging from $10,000 to $299,900 in $100 increments. For the
highlighted results, taxable incomes as close as possible to the
actual bracket midpoints were selected. For the 10 percent tax
bracket, a family with an adjusted gross income of $10,000 was
TXPD item was reported for very few firms in years before 1990,
data for the years 1990 through 2001 were used.
definition for OANCF is "the net change in cash from all items
classified in the Operating Activities section on a Statement of