Dividend Policy and the 2003 Tax Cut: Preliminary Evidence

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Dividend Policy and the 2003 Tax Cut: Preliminary Evidence

October 25, 2004 6 min read

Authors: Norbert Michel and Ralph Rector

Two recent National Bureau of Economic Research (NBER) papers begin the formal study of whether the 2003 dividend tax cuts affected corporate dividend policy. Economists have debated for years whether lowering individuals' taxes on dividends would lead to increased corporate payouts, and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) provides a testable event to study. This article provides a brief summary of the dividend tax law changes in JGTTRA, the debate over dividend tax policy, and the new studies from NBER.

The new research discussed here includes NBER Working Papers No. 10301, by Jennifer Blouin, Jana Raedy, and Douglas Shackelford, and No. 10572, by Raj Chetty and Emmanuel Saez.[1] JGTRRA dramatically reduced individual income tax rates on dividends, and the early research suggests that these tax cuts did influence corporate behavior. The NBER research also indicates that JGTRRA's phase-outs and potential repeal may have influenced corporate payout policy.


What Did JGTRRA Change

A key feature of JGTRRA, passed in May 2003, was a reduction in the maximum individual tax rate on dividend income. Prior to JGTRRA's passage, dividends were taxed at rates identical to other types of "ordinary" income, such as wages and interest. Consequently, a taxpayer in the top tax bracket in 2003 would have faced a 38.6 percent tax rate on both wage and dividend income.

JGTRRA lowered the top individual tax rate on dividends from 38.6 percent to 15 percent, and ensured that dividends and net capital gains would be taxed the same.[2] For both capital gain and dividend income, taxpayers in the top four tax brackets are now subject to a 15 percent tax rate, while taxpayers in the bottom two brackets have a rate of 5 percent. JGTRRA provides additional tax relief because this 5 percent rate for the low-income groups falls to zero after 2007.

The relief is short-lived, however, because the pre-JGTRRA dividend rates return for everyone after December 31, 2008. Moreover, Democratic presidential candidate John Kerry has pledged to repeal the dividend tax cut for taxpayers in the top two tax brackets. The new NBER studies suggest that JGTRRA has influenced corporate dividend policies, but also indicate that the law's "temporary" nature has not gone unnoticed.


The Debate

The debate over the impact of lowering individual tax rates on dividends ranges from the banal to the highly technical. For instance, some detractors of the 2003 dividend tax cut argued that corporations would not pay higher dividends because the law did not directly benefit corporate profits. Others felt firms would not increase their dividends because institutional shareholders, such as pension funds that don't pay taxes, hold the most sway over corporate dividend policy. Those in favor of the dividend tax cut argued that the double tax on corporate dividends lowered investment and provided a harmful incentive to keep excess cash in the firm rather than return it to shareholders.

In the circle of academia, the impact of JGTRRA can be summed up as a debate between followers of the "old view" vs. the "new view." Under the old view, because dividend taxes lower the return on investment, cutting the dividend tax would lead to higher dividends and new investment. The new view, on the other hand, argues that because most new equity financing comes from retained earnings rather than selling new equity shares, cutting individual dividend taxes will not spur new investment.[3] The latest research from the NBER does not settle this debate, but it does suggest individual tax incentives affect corporate dividend policy.


The Most Recent Research

The two NBER papers discussed here were released in February and June of 2004. Because just a short time has elapsed since JGTTRA was signed into law, both sets of authors acknowledge that their work only begins to study the issue of whether JGTRRA influenced corporate dividend policy. Still, the findings in those papers are consistent with early media accounts of increased dividend payouts and higher preferences for dividend-paying stocks after JGTRRA passed.[4]

The first paper, by Blouin et al., finds that firms listed on the major U.S. stock exchanges increased their dividends in the quarter immediately following the passage of JGTRRA.[5] The authors report that aggregate dividends rose 9 percent in the quarter after the law was enacted. However, the Blouin paper also reports that large "special" dividends (rather than regular dividend payments) are responsible for most of this dividend increase.

This last finding is particularly interesting because corporate boards go out of their way to avoid decreasing their regular dividend payments. In other words, most boards of directors are unlikely to increase their regular dividend payments (which are usually paid to shareholders each quarter) if they believe they will have to decrease those payments soon after. For shareholders' tax purposes, however, both special and regular dividends are treated the same.

Given that JGTRRA's dividend tax cut is set to expire in a few years (and could be partially repealed in 2005), corporate directors could reasonably choose the special dividend as the safer way to return cash to shareholders. Both types of dividends provide the same direct benefits to shareholders, but choosing the special dividends ensures that the board won't have to cut its regular dividend payment in the face of new tax law changes. The Chetty and Saez paper also reports that special dividends increased after JGTRRA passed.[6]

The second paper includes two additional quarters of data and points out that, while special dividends did rise, many firms increased their regular dividend payments after the tax cut. Because the aggregate amount of dividends is severely affected by an outlier problem (a small number of firms with large dividend payments), the paper focuses on the number of firms paying dividends. Chetty and Saez find that "the fraction of publicly traded firms paying dividends began to increase precisely in 2003 despite having declined for more than two decades."



Economists have been debating the impact of individual dividend tax cuts for many years. It is still too early to make definitive conclusions, but the early returns suggest that JGTRRA did provide an incentive for corporate boards to increase their dividend payouts. The findings of two new NBER papers are consistent with early media accounts of increased dividend payouts and higher preferences for dividend-paying stocks after JGTRRA was signed into law. Early research also suggests that because JGTRRA is set to expire in 2008 and could be partially repealed after the upcoming presidential election, the law's impact on regular dividend payments could be muted. It is almost certain that the law will not produce the long-run benefits its advocates hoped for if, in fact, corporate managers are treating JGTRRA as temporary.


Norbert J. Michel, Ph.D., is a Policy Analyst, and Ralph A Rector, Ph.D., is a Research Fellow and Project Manager, in the Center for Data Analysis at The Heritage Foundation. A version of this WebMemo originally appeared in the August 23, 2004, issue of Tax Notes.

[1] Jennifer L. Blouin, Jana S. Raedy, and Douglas A. Shackelford, "Did Dividends Increase Immediately After the 2003 Reduction in Tax Rates?" National Bureau of Economic Research Working Paper No. 10301, February 2004; and Raj Chetty and Emmanuel Saez, "Do Dividend Payments Respond to Taxes? Preliminary Evidence from the 2003 Dividend Tax Cut," National Bureau of Economic Research Working Paper No. 10572, June 2004.

[2] The law did not reduce the tax on long-term capital gains from collectibles, small business stock, or Section 1250 gains. See 2003 Tax Legislation: Law, Explanation and Analysis, CCH Tax and Accounting, 2003.

[3] According to one study, there are certain conditions under which the "new view" would hold and dividend payments would increase after the tax cut. See Alan Auerbach and Kevin Hassett, "On the Marginal Source of Investment Funds," Journal of Public Economics, Vol. 87, No. 1 (2003), pp. 205-232.

[4] See Craig Shaw, "Dividends Are Climbing Since 2003 Tax Cuts; Investors Start Noticing S&P," Investor's Business Daily, March 30, 2004, p. A01.

[5] Blouin et al, "Did Dividends Increase Immediately After the 2003 Reduction in Tax Rates?"

[6] Chetty and Saez, "Do Dividend Payments Respond to Taxes? Preliminary Evidence from the 2003 Dividend Tax Cut."


Norbert Michel
Norbert Michel

Director, Center for Data Analysis

ralph rector
Ralph Rector

Former Senior Research Fellow