Are Dividend Taxes Harmless? Don’t Bet On It!

Professor Danny Yagan recently published a paper in the American Economic Review that concludes that the dividend tax cut enacted as part of the Bush 2003 tax reduction did nothing to promote investment, and that it may not be possible to design effective pro-growth dividend relief.[1] The conclusion appears to be based on flawed assumptions and questionable procedures.

In 2003, qualified dividends, which had been treated as ordinary income, were given the same tax treatment as long term capital gains, and the top tax rate on both was lowered from 20% to 15% (and zero percent for taxpayers in the ordinary 10 and15 percent brackets). Yagan noted that the 2003 tax rate cut on dividends would only affect the cost of capital for C-corporations, and not for S-corporations. C-corporation income is subject to the corporate income tax and, when distributed to shareholders, the individual tax on dividends. S-corporation income is only subject to the individual tax on business income.

Therefore, one might be able to gauge the effect of the dividend rate cut on investment by noting any subsequent difference in the rate of growth of investment between C-corporations and S-corporations. If the dividend cut mattered, one should see faster growth in investment by C-corporations than by S-corporations after the tax cut. Yagan found no such differential, and concluded that the dividend tax reduction did not spur investment by C-corporations.

This method depends on tax relief occurring for C-corporations but not S-corporations. However, the 2003 Bush tax cut also reduced taxes on S-corporations, partnerships, and proprietor­ships. Individual marginal tax rates were lowered in stages by the 2001 tax cut. The cuts were small in 2001 and 2002, but the tax act of 2003 moved forward the remaining rate reductions to speed recovery from the 2001 recession. The bills also gradually phased out limits on personal exemptions and itemized deductions for upper income taxpayers (PEPs and Pease provisions). There were ongoing cuts in estate and gift taxes from the 2001 Act.

We used the Tax Foundation Taxes and Growth Model to estimate the combined effect of these other tax provisions on the service price of S-corporations. By 2008, they cut the service price for capital employed in S-corporations roughly 60 percent as much as the dividend changes did for capital employed in C-corporations. This greatly diminishes the differential changes between the two sectors that Yagan relies on for his test. The differential would have narrowed further in 2010 as PEPs and Pease and the estate tax were to have ended.

Yagan acknowledges the personal rate cuts for non-corporate business owners, but he assumes that the non-corporate rate cuts, which were enacted in 2001, had most of their influence before 2003, and less influence on non-corporate investment between 2003 and 2008. But most of the rate reductions were phased in and did not take effect until 2003. Also, capital goods must be ordered, built, and put in place. It takes time for investment to change following a change in the incentives. The non-corporate rate cuts were a more important influence on S-corporations after 2003 than before. With so little to distinguish the two sectors, any effect on investment due solely to the dividend cut would be difficult to spot using Yagan’s methodology.

Yagan attempted to further isolate the effect of the tax change on dividends by accounting for, and subtracting, the adjustments in investment due to some other tax modifications, including the “bonus expensing” provision of the 2003 Act. In 2002, Congress enacted 30 percent bonus expensing, letting all businesses immediately claim 30 percent of the cost of equipment as a business expense, depreciating the remaining 70 percent under usual cost recovery schedules. In 2003, the bonus expensing share was increased to 50 percent of the cost of equipment.

Stripping estimated effects of some causative factors from a data set before analyzing the effect of a remaining variable can inject serious errors into the results. The technique loses some of the interactions that may exist between one tax provision and another in setting the cost of capital. Analyzing the variables alone cannot do as well as a full calculation of the effect of all the tax changes on the cost of capital. A deeper issue is that the effects of other variables are not known with certainty. They are only estimated, and the estimates contain errors. Subtracting estimated effects alters the data set yet to be analyzed. One is then comparing the effect of the change in the dividend to an investment path that is the sum of yet-to-be-explained investment and whatever error terms were introduced by the estimation procedure. Since the latter are of unknown size and direction, there is no way to tell if the relationship between the dividend changes and the amended residual investment figures is valid. It could be exaggerating the effect of the dividends on investment, or understating it, or getting it just right, but there is no way tell.

Additionally, many of the larger, capital intensive C-corps were not included in the sample. Larger C-corporations, including major utilities, are more likely to pay dividends than smaller ones, and do a large amount of investing. In examining the data for individuals, Yagan used only the change in the top tax rate on dividends, rather than a weighted average of the marginal dividend rate reductions across tax brackets. The latter would be a better parameter. Another issue is the time period used in the comparison – 2008 versus 2003. Investment in equipment and structures fell in the 2001 recession. Investment in equipment rose in 2003-2006; investment in structures stabilized. Equipment grew more slowly in 2007-2008; structures accelerated. Both faced headwinds in 2008 and beyond as the financial crisis took hold. The result of the study might have been different if it had compared 2006 to 2003.

Finally, as initially enacted, all the Bush 2001 and 2003 tax cuts were temporary. Dividend and capital gains rate relief was originally due to expire at the end of 2008. It was extended through 2010 in the Tax Increase Prevention Act of 2005, and was extended through 2012 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The cuts in ordinary income rates were set to expire at the end of 2010, and were extended through 2012 by the 2010 Act. No permanency was achieved until after the Affordable Care Act of 2010, and the Fiscal Cliff deal passed in December 2012 and signed into law January 2, 2013. These boosted the top tax rate on dividends and capital gains to 23.8% and on ordinary income to 39.6%, and restored PEPs and Pease. The temporary nature of the initial tax cuts, and their different expiration dates, may have affected investment decisions adversely, in a manner hard to estimate.

In conclusion, Professor Yagan’s study does not provide a convincing argument that dividend relief did nothing to boost investment or that double taxing dividends is not detrimental to capital formation.

[1] Danny Yagan, “Capital Tax Reform and the Real Economy: The Effects of the 2003 Dividend Tax Cut,” American Economic Review 2015, 105(12): 3531–3563

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