divtaxes - 1 Dividends and Taxes An Analysis of the Bush...

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1 Dividends and Taxes: An Analysis of the Bush Dividend Tax Plan Aswath Damodaran March 23, 2003 Stern School of Business 44 West Fourth Street New York, NY 10012 [email protected] Professor of Financc
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2 Abstract What are the implications of making dividends tax free to investors? This question is now very much on the minds of investors and corporate finance practitioners after President Bush proposed it as part of his economic package in early 2003. While much of the debate has concentrated on the consequences of the tax law change for the stock market and budget deficits, the real effects may be in how companies raise money (debt versus equity), how much cash they choose to accumulate and how they return this cash to stockholders (dividends versus stock buybacks). If the tax law changes occur as proposed, it will profoundly alter the terms of the debate and require us to rewrite much that we take for granted in corporate finance today. In particular, we believe that over time, you will see companies become more (if not entirely) equity financed, a decrease in cash balances and a dramatic surge both in the number of companies that pay dividends and in how much they pay.
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3 On January 8, 2003, President Bush proposed a dramatic change in the tax laws when he suggested that dividends be made tax exempt to the investors who receive them. Since the inception of the income tax in the early part of the 20 th century, investors have had to pay taxes on dividends, which in turn were paid out by corporations from after-tax income. The double taxation of dividends, once at the hands of the corporation and once in the hands of investors, contrasts with the tax code’s treatment of interest expenses – they are deductible to the companies that pay them. This asymmetric treatment of debt and equity has formed the basis for much of the debate in corporate finance on whether firms should use debt or equity and how much firms should pay out to their stockholders in dividends. It has also been built in implicitly into the models that we use to value stocks. In this paper, we will consider the implications of the tax law change for both valuation and corporate finance practice. We will begin by presenting a history of the tax treatment of dividends in the last century and provide a contrast with its treatment in other countries. In the next section, we will consider how the tax treatment of dividends is built implicitly into valuation models and the consequences of changing the tax law on valuation. In the third section, we will consider how the tax disadvantage associated with dividends has been built in explicitly into corporate financial analysis and how the discussion will change if the tax law is changed. In the last two sections, we will consider the effects of the tax law on other markets and for the economy.
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divtaxes - 1 Dividends and Taxes An Analysis of the Bush...

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