The Short-Term Reaction To The Dividend Tax Reduction

Abstract

With the passage of the Jobs and Growth Reconciliation Act of 2003, the maximum tax rate on dividend income was lowered from 38.6% to 15%.  This eliminated the traditional tax disadvantage that dividend income had relative to capital gains income.  Theoretically, this should have led a significant number of firms to increase their dividend payments.  In an empirical analysis of firm dividend payments after the dividend tax reduction took effect, it was found that there was a statistically significant increase in the number of firms raising their dividends.  For example, in the third quarter of 2003, 4.6% more firms increased their dividends than did so in the third quarter in 2002.  Similarly, 4.9% more firms increased their dividend payments in the fourth quarter of 2003 than did so in the fourth quarter of 2002.  A logit regression analysis of dividend changes showed that most of the change in the number of dividend increases was caused by the dividend tax reduction and not other factors such as earnings, earnings stability, investment opportunities or firm size.  The logit regression analysis also indicated that the dividend tax reduction increased by 3.7% (4.2%) the probability that the average sample firm would increase its dividend payment in the third (fourth) quarter of 2003.  It was also found that the greater a firm's blockholder share ownership the less likely the firm was to increase its dividend payment following the dividend tax reduction.  CEO and other officer and director share ownership were found to be unrelated to the probability that a firm would increase its dividend payment.