Dividend Tax Cut Benefits Only a Few

Author: John Maggs

Published: February 28, 2004

President Bush promised that last year's cut in taxes for stock dividends would unleash billions of dollars in payments to the 21 million U.S. households that own stock.

But new research shows that substantially all of the benefits went to the owners of just 17 closely held companies. They responded to the tax cut by paying out $800 million in special onetime dividends to a small number of shareholders.

Managers and officers, who own a disproportionately large share of these 17 companies, paid themselves $175 million in dividends, in some cases explicitly citing the Bush tax cut as justification. Meanwhile, the other 1,200 public companies that pay dividends ignored the tax cut, and the vast majority of America's stockholding households got virtually nothing.

It was always clear that most of the tax cut would go to the rich, since they own most stock. But it is startling, even to Bush's critics, that the money would go to so few. "If it is true, then I guess the dividend cut was worse, in even more ways, than anyone suspected," said William Gale, an expert on tax policy at the Brookings Institution.

The results are published in a paper by three business-school professors who pored over quarterly dividend declarations and earnings statements from hundreds of publicly traded companies. Jana Smith Raedy, an accounting professor at Kenan-Flagler Business School at the University of North Carolina in Chapel Hill, said she and her co-authors thought the dividend tax cut enacted last May was a good idea and are surprised that it didn't have a wider impact.

The paper covers the initial reaction of corporations in the first three months after the tax cut took effect, but Raedy cites a number of reasons why she and her colleagues expect the trend to continue. Within its jumble of economic jargon and equations, the paper contains a serious indictment of the idea that cutting dividend taxes will unlock trillions of dollars that companies piled up during the 1990s boom.

In fact, despite the Bush administration's optimistic predictions about the broad and sizable economic benefits of the dividend tax cut, plenty of evidence suggested beforehand that it wouldn't work that way, according to the paper. The paper is available at Nber.org/papers/w10301, on the Web site maintained by the National Bureau of Economic Research.

As he has characterized other tax cuts, Bush portrayed the dividend cut in moral terms. Because corporations pay income tax, and then shareholders pay income taxes on the dividends that distribute those corporate profits, earnings are taxed twice, something the president called "wrong," and Senate Majority Leader Bill Frist, R-Tenn., seconded as "immoral." The cut lowered the dividend tax rate from a range up to 38.1 percent, to a flat rate of 15 percent for virtually all dividends. According to the White House, the tax cut would give companies that hadn't paid very much in dividends a fresh incentive to do so, and the new dividends would make shares more valuable, boosting stock prices from 5 percent to 15 percent.

But Raedy and her co-authors cite a number of flaws in that rosy scenario. For starters, dividends have fallen out of favor for reasons that have nothing to do with the tax rate. Corporate managers like to retain earnings to reinvest or to acquire competitors, and there are tax benefits for investors when cash is used to repurchase stock. At the end of 2002, only 70 percent of Standard & Poor's index of 500 large companies were paying dividends, down from 94 percent in 1980. In a 2003 survey, 69 percent of chief financial officers said that even elimination of the dividend tax probably wouldn't lead them to raise their dividends.

More important, it was known before the tax cut that dividends are concentrated among a few firms. One study finds that just 25 companies accounted for more than half of the total dollar amount of dividends paid in 2000.

At first blush, Raedy's conclusions seem only a slight disappointment for the White House. A year ago, administration officials predicted that the dividend tax cut would deliver $20 billion "for millions of stockholders ... this tax year alone." Being charitable with the White House's timeframe, the results seem in the ballpark -- after three months, dividends rose $3.2 billion, or at an annual rate of $12.8 billion. But Raedy and her co-authors, Jennifer Blouin and Douglas Shackelford, found that three-quarters of that initial $3.2 billion was unrelated to the tax cut. By controlling for other factors, such as the recovering economy, they discovered that the number of companies that altered their dividend payouts was so small as to be "statistically insignificant." On the other hand, they found that 17 closely held companies, most of which hadn't paid dividends before, were motivated by the tax cut to pay out $799 million to investors in onetime dividends. The authors found "no evidence that firms responded to the legislation by increasing their regular, quarterly dividends." according to the paper.

The largest of the 17 companies was SBC Communications, one of the Baby Bells, which paid a special dividend of 10 cents a share to its millions of shareholders. But more typical was Iomega, maker of Zip drives and other computer accessories, which has struggled to stay profitable since the technology slump in 2000. Iomega earned only about $5 million through the first three quarters of 2003, but on October 1, it paid out $257 million in a special dividend. That payout took more than half of the company's cash reserves -- all of which were residing in offshore accounts to avoid taxes. According to CEO Barry Zwarenstein, Iomega decided that, despite tiny earnings, the cash could best be used to pay shareholders, who have seen their shares plunge in value after 2000. It was also an opportunity to avoid $100 million in tax liabilities for repatriating the money from offshore, he told Wall Street analysts last year.

The ownership of stock shares in the 17 companies is dominated by managers and corporate officers. Of the 1,200 companies the researchers studied, the average portion of stocks held by such insiders was 8 percent. But the average of insider-held stock for the 17 that made the biggest payouts was 22 percent, according to data from Thompson Financial. This means that $175 million of the $800 million payout by this handful of companies went to company insiders. In the case of one company, Sun Hydraulics, whose stock is 38 percent owned by insiders, the company specifically attributed the idea of the payout to its largest shareholder, retired chairman Robert Koski. For all 17, "a casual review of press releases announcing the special dividends confirms that the [tax cut] spurred the special dividends," the researchers reported.

Gale said it is not surprising that the Bush tax cut hasn't changed corporate attitudes about dividends. "A dirty little secret is that CEOs like double taxation, because they want to retain earnings to play around with," he said.

This is not the first time that a Bush tax cut has failed to perform as advertised. An earlier decision to speed up depreciation for businesses, purportedly to encourage them to invest in new equipment, didn't boost capital spending, since most companies had overinvested in equipment before the recession. Raedy said that corporate leaders might change their minds about dividends over time. In the meantime, the main effect of the tax cut is special payouts to stockholders of closely held firms.