proposal to end the double tax on dividends has met with
considerable controversy. Opponents claim that dividend tax relief
would benefit only the wealthiest taxpayers, while supporters claim
that it would spur new corporate investment, leading to additional
jobs and higher incomes. This Report provides evidence that
the plan would spur higher job and income growth.
By estimating the weighted average cost of capital for a sample of
87 publicly traded firms in Ohio, we found that the President's
plan would have lowered their cost of capital by an average of
about 2.7 percent.
In fact, Ohio companies with a market value of more than $1 billion
would have realized an average decrease of 3.45 percent. (See Table 1.)
Since it would lower firms' cost of capital, the Bush proposal
would provide the incentive for higher corporate investment.
When deciding whether to undertake capital projects, such as
investing in buildings, equipment, and machinery, corporate
managers estimate expected profits. To estimate a project's profit
(or return), managers compare the amount of money they expect the
project to bring in to the cost of the funds needed to undertake
it. To be profitable, therefore, the project's rate of return must
be at a level at least as great as the firm's cost of capital. Any
project below that level would be expected to lose money and, as a
result, would not be undertaken.
In other words, corporate managers increase their investments when
the cost of the funds (the capital) needed to invest in projects
falls. Any project with an expected return (profit) greater than
the firm's cost of capital will be undertaken because it is
expected to be profitable. Examining individual investors'
effective tax rates on dividends reveals one reason that the
President's proposal lowers firms' cost of capital.
We used Heritage's Individual Income Tax Micro-Simulation Model to
calculate effective personal tax rates under current law and under
the President's proposal for a set of hypothetical investors. Using
the midpoint taxable income levels of each bracket, these estimates
show effective tax rates
on dividends for married joint filers (without children) in the
first five federal income tax brackets. (See Table
For a couple in the 10 percent tax bracket with a taxable income of
$6,050, the effective tax rate on dividends drops from 32.5 percent
under current law to 25 percent under the Bush proposal (a decrease of 23.08 percent).
For a couple in the 27 percent tax bracket with a taxable income of
$81,078, the effective tax rate on dividends falls from 45.25
percent to 25 percent (a decrease of nearly 45 percent).
Given such a decrease in effective tax rates, it is reasonable to
assume that implementing the President's plan would cause corporate
managers to reassess their cost of equity capital. In addition, the
Bush plan would lower firms' cost of capital by giving shareholders
a basis adjustment for cash retained in the firm, thus lowering
effective personal capital gains tax rates. The mechanics of this
basis adjustment are illustrated below using MCSi, Inc., a
non-dividend-paying company based in Ohio.
At the end of fiscal year (FY) 2002, MCSi, Inc., had a market value
of roughly $58 million, net sales of about $810 million, total
assets of approximately $472 million, and roughly 2,000
Using the fiscal year closing prices for 1997 and 2001, we can
assume that an individual buying MCSi shares in 1997 and selling
them in 2001 would have paid about $9 per share and sold at a share
price of roughly $25. Under current law, assuming this investor was
in the 27 percent individual income tax bracket, buying and selling
MCSi shares at these prices would have resulted in an effective
capital gains tax rate of approximately 36 percent ([(25 - 9) *
Under the Bush plan, however, this individual would have been
eligible for a basis adjustment of nearly $4 per share, lowering
the effective capital gains tax rate to about 27 percent ([(25 -
13) * 0.20]/9), a decrease of 25 percent. If, for example, this
investor had purchased 1,000 shares of MCSi, a tax savings of $800
would have been realized ([(25,000 - 13,000) * 0.20] = 2,400
compared to [(25,000 - 9,000) * 0.20] = 3,200).
The President's plan would increase investment by lowering the
effective tax on corporate income, thus making the cost of doing
business and undertaking new investment projects less expensive. Given the size of the
reduction in effective personal tax rates, it is likely that
corporate managers would respond to the tax consequences of the
President's plan. Over time, lowering the cost of capital by ending
the double tax on corporate income would lead to higher economic
growth and widespread economic benefits.
Weighted Average Cost of
To estimate the
weighted average cost of capital (WACC) for the sample of publicly
traded companies in Ohio that was used in this report, we employed
the following equation:
WACC = wdkd(1 - tc) +
wdkd * td +
wsks + [ws(D1 *
tdiv/P0 + g * teffcg)]
where wd is the ratio of total debt to total
assets, kd is the interest rate paid on debt,
tc is the firm's average marginal tax rate,
td is the debtholders' personal tax rate,
ws is the ratio of total equity to total assets,
and ks is the cost of equity. The last term in
the WACC equation, [ws(D1 *
tdiv/P0 + g * teffcg)], is an
expanded version of the cost of equity capital,
The cost of equity capital, ks, was estimated
using the "constant growth" model (or Gordon model):
ks = D1/P0 + gwhere
is the after-tax dividend shareholders expect to receive,
P0 is the price of the shares purchased, and
g is the firm's after-tax equity growth rate (a substitute
for the expected rise in the stock price). This formula assumes
that both dividends and equity grow at constant rates for the
period in question, and it is also expanded into the form
[ws(D1 * tdiv/P0 + g
* teffcg)] to account for personal taxes on
corporate equity. The term tdiv is the statutory
personal tax rate on dividends, and teffcg is the
effective personal tax rate on capital gains.
Most of the parameters for the WACC equation were estimated using
publicly disclosed financial data as reported in Standard and
Poor's Compustat database.
First, all publicly traded companies incorporated in Ohio were
pulled from the database, providing a sample of 156 corporations.
Next, based on several key data items during the period of 1997 to
2001, any firm missing data items was excluded, paring the sample
from 156 to 87 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
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 25 percent was used (see
below). 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 estimate.
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 fiscal year closing
price (S&P data item PRCCF). 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.
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 follows:
teffcg = tscg(P1 -
tscg is the
statutory tax rate on capital gains, P1 is the 2001
closing share price, and P0 is the 1997 closing share
price. The statutory tax rate on capital gains, tscg, was
assumed to be 20 percent. To estimate the cost of equity capital,
ks, under the Bush plan, the excludable distribution
amount (EDA) was estimated for each company.
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 / 0.35) - U.S. income taxes
U.S. income taxes paid the prior year are used to calculate the EDA
for the current year.
To estimate the EDA for the 87 companies in the sample, cash paid
in taxes (S&P item item "TXPD") was used. The amount of the
excludable dividend was then estimated as the EDA divided by the
number of common shares outstanding at the close of the given year.
The basis adjustment was then estimated by subtracting the
per-share excludable cash dividend from the per-share EDA (the EDA
divided by the 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
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 Report are the effective dividend tax rates for
married couples with taxable income near the midpoint of the first
To estimate the effective personal tax rates, an average corporate
income tax rate was estimated using Standard and Poor's (S&P)
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 rates.
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).