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 2.)
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 employees. 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) * 0.20]/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 Capital
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, ks.
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 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 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.
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 follows:
teffcg= tscg(P1 - P0)/P0
where 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.
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 / 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.
Effective Personal 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).
 See also Norbert J. Michel, Ralph A. Rector and Alfredo Goyburu, "How the President's Dividend Plan Would Increase Corporate Investment," Heritage Foundation Center for Data Analysis Report No. 03-TK.
 This estimate assumes a holding period of 1997 to 2001. For more details, see the methodology note.
For this reason, the level that determines whether a project is profitable is sometimes referred to as the "hurdle rate." 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 www.heritage.org/Research/Taxes/wm248.cfm.
 Both corporate and personal taxes reduce the amount of cash that is actually returned to shareholders thus increasing the firm's cost of equity capital. This principle applies to both dividend and capital gains taxes.
The 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 methodology note.
The term "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.
 MCSi, Inc. (MCSI) provides integrated technical services and audio-visual presentation and broadcast products. The company designs and integrates custom configured and integrated audio, video and data display, broadcasting, conferencing and networking systems.
For details on the mechanics of the basis adjustment, see the methodology note.
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.
Taken 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.
The 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).
 The final sample of 87 firms represented 56.51 percent of the full sample's (156 firms) reported market value (as of fiscal year 2001). Market value was not reported in the Compustat database for 3 companies in the full sample.) A list of all companies is available upon request.
The commercial paper rate was used for eleven 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.
To estimate 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. To access the corporate bond yield series, see Federal Reserve at research.stlouisfed.org/fred/data/irates/aaa.
According 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.
According 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. For more on the proposed rules, see U.S. Department of the Treasury at www.ustreas.gov.
CDA 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 used.
Since the TXPD item was reported for very few firms in years before 1990, data for the years 1990 through 2001 were used.
The S&P definition for OANCF is "the net change in cash from all items classified in the Operating Activities section on a Statement of Cash Flows."