Order Code RL31824
CRS Report for Congress
Received through the CRS Web
Dividend Tax Relief:
Effects on Economic Recovery,
Long-Term Growth, and the Stock Market
Updated September 20, 2004
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Dividend Tax Relief: Effects on Economic Recovery,
Long-Term Growth, and the Stock Market
Summary
Several objectives were advanced for the President’s proposal for dividend relief
to eliminate double taxation of corporate source income including “creating jobs”
(suggestive of a short-run stimulative effect), enhancing long- term growth and
efficiency, “fairness,” and increasing the value of the stock market. (Dividend relief
was enacted on a temporary basis in H.R. 2.)
Short-run stimulus objectives often conflict with long-run growth because an
increase in spending is needed to stimulate an underemployed economy in the short
run while an increase in saving (or labor supply) is needed to increase long-run
growth. The dividend relief proposal is less likely to be successful in stimulating
short-run demand than a spending increase or some other tax cuts because it accrues
to higher income individuals who may save a larger fraction of the cut. It is also
unlikely that this saving effect will be quickly translated into investment spending;
indeed the proposal could decrease spending by shifting assets out of direct
investment in unincorporated business assets and housing and into financial assets.
The longer-run growth effects of the dividend proposal (financed by debt and
measured as changes in standard of living) are likely to be negative. Although the
effects are quite small early on (due to the small size of the cut and the slowness with
which the capital stock changes), they would become quite large over time if debt
financed. This analysis finds that reductions of -0.16% to -0.10% would occur after
10 years, with -0.39% to -0.22% after 20 years. Only very large savings elasticities
well out of the range of empirical evidence could induce even short-run growth that
offsets deficit effects. Positive growth effects may occur if the tax cut is offset by
spending cuts elsewhere and the savings elasticity is positive, but such effects are
small and require a quick offsetting spending decrease. In one simulation, a tax cut
which increased the deficit for 10 years induced negative output effects for over 30
years. These small, likely negative effects were obtained for a variety of assumptions
regarding labor supply and the ability to substitute labor and capital.

Economic analysis would reject a “fairness” argument across investors because
of reallocation of capital. However, reallocation is the key to achieving efficiency
gains that are the main benefit of the dividend relief proposal. The increase in
efficiency is estimated at 0.1% to 0.6% in the long run, although this amount could
be reduced by the limit on preference passthrough.
The effects on the stock market are likely to be small, with an upper limit of 5%
to 6%, but probably much less due to changes in interest rates and expectations of
adjustment. Changes on the order of 2% to 3% may be more likely. Any stock
market effects represent temporary windfalls to holders of current stocks and are
simply a manifestation of the income effects of the tax cut; these wealth effects
should not be considered as an additional stimulus. There is little evidence of general
effects on spending through consumer confidence and the effect is quite small to
function as a signal. This report describes basic economic relationships and will not
be updated.

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Contents
Short-Run Stimulus and Long-Term Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Short Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Long-Run Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Effects of Savings Elasticities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Effects of Labor Supply and Factor Substitution Elasticities . . . . . . . . 4
Conditions Favorable to Positive Effects . . . . . . . . . . . . . . . . . . . . . . . . 5
International Capital Inflows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Neoclassical Growth Versus Life Cycle Model . . . . . . . . . . . . . . . . . . . 6
Overall Effects on Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Reallocation of Capital (Portfolio Effects) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Tax Exempt Shareholders and Tax Preference Passthrough Limits . . . . . . . . . . . 8
The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
An Overview of Economic Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Estimated Stock Market Effects: A Standard Analysis . . . . . . . . . . . . . . . . 11
Cost of the Tax Cut . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Discount Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Stock Market Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Method of Calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
The Trapped Equity or “New” View of Dividends . . . . . . . . . . . . . . . . . . . 15
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Adjustment and the Stock Market Value . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
The Trapped Equity or New View of Dividends . . . . . . . . . . . . . . . . . . . . . 21
List of Tables
Table 1. Percentage Increase in Income Available for Consumption from
Dividend Relief, Depending on the Size of the Savings Elasticity (E),
Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Table 2. Percentage Increase in Income Available for Consumption:
Sensitivity to Labor Supply (8) and Factor Substitution (S) Elasticities . . . . 4
Table 3. Percentage Increase in Income Available for Consumption, Effects
of Large Savings Elasticities (E) and Deficit Offsets via Spending Cuts . . . 5
Table 4. Percentage Increase in Income Available for Consumption, Effects
of International Capital Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

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Dividend Tax Relief:
Effects on Economic Recovery,
Long-Term Growth, and the Stock Market
Several objectives have been advanced for the President’s proposal for dividend
relief to eliminate double taxation of corporate source income, including “creating
jobs” (which is suggestive of a short-run stimulative effect), enhancing long-term
growth and efficiency, “fairness,” and increasing the value of the stock market. This
report discusses these effects. After providing a general analysis of the effects of tax
cuts on short- and long- run growth, the paper discusses three additional aspects of
the proposed dividend revision: reallocation of capital (and its implications for
fairness and efficiency), preference passthrough restrictions, and the role of the stock
market. (Dividend relief was enacted in 2003 on a temporary basis, in H.R. 2).
Short-Run Stimulus and Long-Term Growth
One of the confusing aspects of economic policy is that policies that are
effective for short-term stimulus purposes tend to reduce long-term growth.
Spending promotes short-run growth; saving promotes long-term growth. It is
particularly hard to devise an individual tax cut that can accomplish its short-run
purpose effectively without undermining long-term growth, absent some other future
policy. And, while there may be circumstances where fiscal stimulus is desirable
(i.e., when interest rates are extremely low initially or a contraction is severe), many
economists feel that the primary tool of economic stabilization should be monetary
policy. This view is reinforced by the leakage of fiscal stimulus (but not monetary
stimulus) that occurs in an open economy.
Short Run
In the short run, to stimulate the economy through fiscal policy requires an
increase in spending — on consumption, on investment, or on government purchases.
The most direct way to accomplish this effect is through spending by the government.
Spending increases add to the deficit and reduce the capital stock which can be
harmful to long-run growth, but if the spending increase is temporary, this effect will
be small. The major problem with spending is that spending programs are often
difficult to agree upon and put into place in a timely fashion (although if cutbacks are
already planned, a delay of the cutbacks would be relatively easy). Emergency
spending can also be wasteful, and it may be difficult to reverse the spending increase
in the future once groups have a stake in it.
Nevertheless, stimulating the economy through increasing private incomes
(through transfers or tax cuts) is likely to be less effective and more problematic than

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CRS-2
spending increases for two reasons. First, there is at least some reason to believe that
much of a temporary tax cut will not be spent initially, but rather will be spread over
a long period of time. Permanent tax cuts or transfers, which may be more successful
in inducing spending, add to the deficit every year, and so reduce the long-run
accumulation of capital. Reversing purportedly permanent tax cuts after granting
them undermines the belief that tax cuts will be permanent and interferes with their
future effectiveness. Secondly, individuals are likely to save some fraction of income
(even permanent income) and saving does not increase aggregate demand. This
effect is, however, probably not very important. Both of these problems are likely
to be less serious with transfers or with tax cuts directed at lower income individuals,
who are more likely to be liquidity constrained in their spending (and thus would
spend all the tax cut) and who tend to have lower savings rates. In these cases tax
cuts, particularly temporary ones, are likely to be more effective if directed at lower
income individuals.
One of the potential ways to provide tax cuts that are effective stimulants
without undermining long-run growth through deficit financing is to provide
investment incentives to firms. If firms directly increase their investment in response
to a tax cut, the induced private investment expands demand in the short run and also
offsets the reduction in the capital stock. Tax subsidies for investment may not,
however, work very well if firms with excess capacity (typical in a sluggish
economy) cannot be easily encouraged to spend. In this case, however, a temporary
tax cut is actually more effective than a permanent one because it encourages firms
to accelerate their capital investment program. Such a temporary tax cut (bonus
depreciation) was enacted in 2002.
How does dividend tax relief — and specifically a provision that provides a
dividend exclusion and future capital gains exclusion for earnings retained — fit into
this standard analysis? As a permanent provision, it is more likely to result in a
stimulus. Dividend relief tends to be directed at relatively high income individuals
who are less likely to spend, so it might be somewhat less effective than tax cuts
aimed at lower income individuals. If the tax cut induces an increase in the savings
rate, the stimulative effect would be smaller (although the effect on the savings rate
could go either way, as discussed below). Nor is the tax cut likely to be very
effective at inducing investment spending by a firm for several reasons. First, the
incentive is provided to the individual who receives the benefit rather than the firm;
this approach results in a more indirect route to investment stimulus. Second, even
if the firm responds quickly on behalf of its shareholders, this type of tax cut largely
benefits earnings from existing capital and is one of the least effective tax cuts for
encouraging investment spending.1 Finally, as discussed below in the section on
portfolio shifts, the reallocation effects of the relief could actually contract
investment spending in the short run.
1 A permanent investment stimulus (e.g., accelerated depreciation) would be more effective
than a rate cut per dollar of revenue loss because a rate reduction provides more of its
benefits for returns to the existing capital stock. A temporary investment stimulus would
be more effective still, but a temporary rate cut could have perverse effects because it could
actually increase effective tax burdens on new investment by reducing the value of
accelerated depreciation. See CRS Report RL31124, Using Business Tax Cuts to Stimulate
the Economy, by Jane G. Gravelle.

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CRS-3
Long-Run Growth
In the long run, the dividend relief proposal will succeed in increasing output
and growth (other than the modest effects associated with economic efficiency) only
if it increases personal saving by more than the revenue cost and accumulating
interest on the debt.2 It is theoretically possible for this effect to occur initially, but
most evidence does not support a large savings response to tax rate changes. Indeed,
some evidence suggests that savings can fall as the rate of return rises (due to wealth
effects). Even large savings responses would eventually result in a deteriorating
capital stock because debt and the interest on debt would compound. Thus, the
dividend relief proposal would harm long- run growth as long as it is based on deficit
finance.
To demonstrate the magnitude and potential direction of these growth effects,
we use a neoclassical growth model with an endogenous savings rate. The details of
this model are presented in the Appendix.
Effects of Savings Elasticities. Table 1 shows the projected effects of the
proposal for various savings elasticities, for the first, fifth, tenth, and twentieth year,
representing a reasonable span of the empirical evidence on savings elasticities.3
Small and possibly negative elasticities are also theoretically consistent with
offsetting income and substitution effects: greater wealth from higher rates of return
increase current consumption but a cheaper price of future consumption reduces
current consumption.
The estimates assume a fixed labor supply (also consistent with empirical
evidence) and a Cobb-Douglas production function. Rather than considering
percentage changes in GDP, a measure reflecting standard of living effects is used:
income available for consumption after accounting for steady state investment
necessary to sustain the capital stock at its current level. This measure could loosely
be interpreted as a change in the sustainable standard of living.4 The percentage
change is similar to the percentage change in output. As Table 1 suggests, the plan’s
projected effects would be to reduce output by a growing amount because the effect
of the deficit on reducing the capital stock is larger than any induced savings
response.
2 In an open economy government borrowing may be offset by foreign net capital inflows.
However, that additional capital cannot contribute to the future standard of living of
Americans other than in a minor way because it and its returns are owned by foreigners.
Note also that the dividend exclusion plan does not apply to foreign shareholders and thus
provides no incentive for increases in foreign equity investment in the U.S.; however, the
provision does provide incentives for equity investment abroad by U.S. firms.
3 See Eric Engen, Jane G. Gravelle, and Kent Smetters, “Dynamic Tax Models: Why They
Do the Things They Do,” National Tax Journal, vol. 50, Sept. 1997, pp. 657-682.
4 This measure also prevents misleading representations from arising from a model where
capital is imported. Since foreign suppliers own the rights to the capital, decreases or
increases in capital stock reflecting foreign imports have limited effects on standards of
living because foreigners have the claim to earnings.

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CRS-4
In none of these cases is the effect on private saving large enough to offset the
contraction in capital. The effects are actually quite small, an outcome that is not
surprising because the dividend relief proposal is relatively small. The negative
effects continue to grow over time as deficits accumulate, and, eventually, the model
“explodes” as deficits displace the entire capital stock.
Table 1. Percentage Increase in Income Available for
Consumption from Dividend Relief, Depending on the Size of
the Savings Elasticity (E), Growth Model
E = -0.4
E = -0.2
E = 0.0
E = 0.2
E = 0.4
Year
1
-0.01
-0.01
-0.01
-0.01
-0.01
5
-0.08
-0.07
-0.06
-0.05
-0.05
10
-0.16
-0.15
-0.13
-0.11
-0.10
20
-0.39
-0.34
-0.30
-0.26
-0.22
Source: CRS calculations, see Appendix. Calculations assume fixed labor supply and factor
substitution elasticity of 1.0.
Effects of Labor Supply and Factor Substitution Elasticities. Table
2 provides for sensitivity analysis, and shows the effects of allowing labor supply to
respond positively to a higher wage and allowing a smaller factor substitution
elasticity (and the combination). A positive labor supply elasticity magnifies a
negative effect (because as the capital stock falls, the wage rate falls), while a lower
factor substitution elasticity has a very small effect (although its effect increases with
a positive labor supply response).
Table 2. Percentage Increase in Income Available for
Consumption: Sensitivity to Labor Supply (8) and Factor
Substitution (S) Elasticities
8 = 0.2
S = 0.5
8 = 0.2, S = 0.5
Year
1
-0.01
-0.01
-0.01
5
-0.07
-0.05
-0.08
10
-0.14
-0.11
-0.17
20
-0.34
-0.25
-0.40
Source: CRS calculations, see Appendix. Calculations assume E = 0.2 and, unless otherwise noted,
8 = 0, S = 1.

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CRS-5
Conditions Favorable to Positive Effects. Are there circumstances where
the dividend relief plan can induce an increase in output? This effect is more likely
to occur when elasticities are positive and large, although even with very large
elasticities eventually the effect on output becomes negative. Another way to
produce a positive effect is to offset the relief plan with some offsetting spending
reduction. Table 3 explores these effects, with some very high savings elasticities
and assumptions that either offset the deficit immediately, or offset the deficit after
10 years.
Higher elasticities can reduce the negative output effects, but only very large
elasticities (clearly far out of the range of empirical estimates) produce short-run
positive effects (and these would also produce contractionary effects for short-run
stimulative purposes). Eventually the effects would turn negative (even the elasticity
of 3 has an effect that peaks at only 7/100 of 1% after about 20 years and becomes
negative after 50 years).
Table 3 also examines assumptions that the deficit will be offset by spending
decreases, in one case immediately and in the other after 10 years. Eliminating the
deficit through a spending offset would increase output, although the amount is likely
to be small for reasonable elasticities. Eliminating the deficit after ten years with an
elasticity of 0.2, however, produces contractions in output for 36 years.
Table 3. Percentage Increase in Income Available for
Consumption, Effects of Large Savings Elasticities (E) and
Deficit Offsets via Spending Cuts
E = 1
E = 2
E = 3
No Deficit
No Deficit
After 10
Years
Year
1
-0.00
0.00
0.01
0.00
-0.01
5
-0.03
0.01
0.04
0.00
-0.05
10
-0.05
0.01
0.06
0.03
-0.11
20
-0.13
-0.01
0.07
0.05
-0.06
Source: CRS calculations, see Appendix. Calculations assume fixed labor supply and factor
substitution elasticity of 1.0. Deficit offset simulations assume E = 0.2.
International Capital Inflows. The negative effects on output could be
offset if assumptions were made that foreign capital inflows would finance the deficit
in excess of private saving. Although imported capital can prevent a decline in
productivity, the returns to that investment are not available for domestic use. The
effects are also sensitive to the level of tax on the earnings of foreign capital. Table
4 provides estimates of the effect on standard of living (where foreigners have the
claim to earnings) in one case where no taxes apply to capital income from abroad

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CRS-6
and in the other case when full taxes apply. The results are the same in direction and
similar in magnitude to those without capital imports.
Table 4. Percentage Increase in Income Available for
Consumption, Effects of International Capital Flows
Year
No Capital Inflow
Full Capital Inflow,
Full Capital Income,
Return Taxed
Return Not Taxed
1 -0.01
-0.01
-0.01
5
-0.05
-0.05
-0.05
10
-0.11
-0.10
-0.10
20
-0.26
-0.21
-0.26

Source: CRS calculations, see Appendix.
Neoclassical Growth Versus Life Cycle Model. The model used in this
analysis is a simplified Solow growth model with an endogenous savings rate which
relies on reduced form empirical elasticities and assume myopia.5 There are also
models that are built up from consumers who maximize utility, and are forward
looking; a model that is currently in use is a life cycle model.6 Forward looking
models cannot be solved at all (even for the initial years) without taking some
measures to address the budget deficit.7 Although behavioral responses are derived
from econometric studies, these models rely on many arbitrary assumptions that
could greatly alter the outcome (in particular, they tend to have large income effects)
and have generally not been empirically tested for reduced form effects.
Overall Effects on Growth. The estimates from these modeling simulations
show that capital income tax cuts, financed by government deficits, induce negative
effects on output in a full employment model, and that these negative effects get
larger over time. The initial effects in either direction are quite small, reflecting the
small size of the tax cuts and the slow adjustment of the capital stock. However,
even if the deficit effects are offset, under reasonable elasticities, these negative
5 Reduced form estimates are derived from regressions of savings rates on observed returns
(and other variables) — a reduced and simplified form of supply relationships that might be
derived from an approach that begins with a utility function for choosing between
consumption across periods.
6 A related model is an infinite horizon model which treats the economy as a representative,
infinitely lived individual. This model would produce positive growth effects because it
forces an infinite savings elasticity, but requires many restrictive assumptions.
7 See CRS Report RL32517, Distributional Effects of Taxes on Corporate Profits,
Investment Income, and Estates, by Jane G. Gravelle for a more detailed discussion of the
issues surrounding savings responses.

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CRS-7
growth effects appear for many years. When gains to future well-being are
appropriately measured, such negative effects cannot be avoided with foreign capital
inflows. Nor is the negative effect an artifact of the type of model: such effects
would also occur with more sophisticated life cycle models as well. Thus economic
benefits of a debt-financed dividend relief proposal must be sought elsewhere. The
next section turns to the classic argument for corporate tax integration.
Reallocation of Capital (Portfolio Effects)
Dividend relief might or might not increase private savings, and it will contract
the capital stock if it is financed by debt, but it should also alter the allocation of
savings from other uses into the stock market. Capital may be withdrawn from debt
(including tax exempt debt), investment in unincorporated business, or in owner
occupied housing. This induced allocation of savings has certain effects, in the short
run as well as the long run, that might be considered.
In the short run, the reallocation of assets could undermine the effects of the
dividend relief provision as a stimulus, if assets are moved from actual physical
investment (such as investments in housing, consumer durables, and unincorporated
business assets). The reallocation of capital out of debt and into equity, which would
have the effect of raising interest rates, depressing bond and housing prices, and
increasing stock market values, could also undermine the stimulus effect if firms are
more sensitive to the effects of interest rates on their investment plans than they are
to stock prices.
In the long run, the reallocation of assets has important implications for two
issues closely associated with corporate tax relief: fairness and economic efficiency.
Although references have been made to the unfairness of the double tax, this
argument is not generally made by economists. A heavier tax on one type of
investment leads to changes in investor behavior (investors withdraw from the
heavily taxed sector and invest in the more lightly taxed sector). The result of this
process is that after-tax returns (net of risk) are equated. Since investors are free to
invest in any type of asset, there is no inequity across taxpayers based merely on
where they invest. There is, however, inefficiency because heavily taxed assets must
earn a higher return before tax than lightly taxed investments.
The tax relief may be considered unfair by some from a vertical equity
standpoint, because higher income individuals receive more of the benefits from the
tax cut.8 Moreover, merely changing a tax provision actually induces some
unfairness across current investors because it provides the taxpayers holding the
assets whose taxes are reduced (in this case, investments in stocks) with windfall
gains, and those holding disfavored assets with windfall losses. For dividend relief,
these windfall gains are captured in a stock market effect which is a subject for
discussion below.
8 See CRS Report RL31597, The Taxation of Dividend Income: An Overview and Economic
Analysis of the Issues, by Gregg A. Esenwein and Jane G. Gravelle.

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CRS-8
The classic economic argument for eliminating double taxation (or, more
generally, integration of corporate and individual income taxes) has always been
efficiency. The current system creates a number of economic distortions, causing too
little capital to be allocated to the corporate sector, debt ratios that are too high, and
payout ratios that are too low. There is some dispute about the magnitude of
efficiency gains but Treasury, using a range of models and assumptions, estimated
gains that ranged from 0.11% to 0.53% of consumption, in a study of integration
released in 1992.9 Most of these efficiency effects would not appear in actual output
increases, but in a more desirable allocation of consumer goods and a more efficient
allocation of risk. However, these improvements in welfare are represented as the
equivalents of dollar increases in output and, at 2001 income levels, these amounts
are between $8 billion and $37 billion. These projected efficiency gains would take
some period of time to occur, as the capital stock shifted between sectors, but would
eventually offset some of the negative effects of a diminished capital stock. (They
would be permanent effects, however, and would not prevent the eventually
explosive effects of continual deficits.)
These effects do not account for a specific aspect of the dividend proposal that
decreases its cost and may reduce the associated welfare gain, the limit on
preferences discussed in the next section.
Tax Exempt Shareholders and Tax Preference
Passthrough Limits
Two provisions limit the benefits — and the revenue loss — of the President’s
approach to corporate tax integration. First, the benefits are not available to tax-
exempt shareholders (e.g., pension funds) or foreign shareholders who do not pay
U.S. individual income tax. Over half of stockholders fall into this position.10
Secondly, there is a restriction on benefits for income that is not subject to tax
because of tax preferences, which probably reduces the tax cuts by around a third.11
9 U.S. Department of the Treasury, Integration of the Individual and Corporate Income Tax
Systems, Taxing Business Income Once, Jan. 1992. The range represents differences in
model assumptions about the substitutability of capital between sectors and how revenue
would be made up (through lump sum taxes or an overall increase in all capital gains taxes).
These effects would be smaller if a “trapped equity” or “new view” of dividends is assumed,
an issue that will be discussed separately.
10 See CRS Report RL31597, The Taxation of Dividend Income: An Overview and Economic
Analysis of the Issues, by Gregg A. Esenwein and Jane G. Gravelle.
11 Tax expenditures are special deductions, exclusions and credits that are considered to
department from a normal income tax. In 2003, tax expenditures were about 65% of tax
liability, implying about a 40% reduction in cost. However, because of the stacking of
dividend relief first, which is subject to higher taxes, the reduction in revenue cost would
be smaller (by as much as a half). Tax expenditures are a little higher than average currently
because of temporary expensing; however, the tax expenditure list may not include all
subsidies.

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CRS-9
These aspects introduce some uncertainty in general into the analysis of effects.
For example, to the extent that tax-exempt holdings are not marginal, the effect on
savings would be larger because the marginal effect would be larger than the average.
It is unlikely however, that this effect would reverse the conclusions that the proposal
will be contractionary for growth. For modeling purposes, if a term were added for
an additional marginal tax rate effect that doubles its size and a substitution elasticity
of 1 plus the base elasticity were used in the growth model discussed above (see
discussion in Appendix), the effects, even for the highest value in Table 1, would
be negligible in the first few years and still eventually turn negative, reducing output
by 0.02% in year 10, and by 0.21% in year 20.
Since tax exempt funds can make portfolio choices, there is less reason to adjust
efficiency effects discussed in the previous section or stock market effects to consider
them infra-marginal.
The second provision restricts tax benefits for income that is preferentially
treated.12 These provisions are designed to disallow dividend exclusions and
increases in basis for income that has not been subject to a tax. There are many
implications of these provisions. While these provisions would not drive a potential
wedge between average and marginal tax rates as in the case of the tax exempt
investors, they make the interpretation of welfare gains more problematic. To the
extent that they preserve differential treatment between corporate and non-corporate
investment, debt and equity, and payout functions compared to a provision that did
not limit tax benefits, they lower the welfare gains of corporate tax integration. If
they discourage activities that were desirable to encourage, the effect would also be
to lower welfare gains; however, if they discourage activities that were not desirable
to encourage, the effect would be to raise welfare gains. Whatever the net effect of
the preference passthrough provision, a better approach if preferences were viewed
as undesirable would be to repeal them outright, as this provision preserves the
benefits for unincorporated business investment and debt finance, but not for
corporate equity investment.

These two aspects of the proposal also may interact. There are incentives for
tax exempt investors to shift to firms that have a lot of preferences and taxable
investors to shift to firms with few preferences, which could result in a larger tax cut
and larger cost.
The Stock Market
There has been considerable discussion of the effect of the dividend proposal
on the stock market. Certainly the decline in the stock market has caused losses to
the financial assets of many individuals, although many observers believed that stock
values were overpriced and that the market would eventually have to decline. Some
12 For an analysis of this provision see CRS Report RL31782, The Effect of the President’s
Dividend Relief Proposal on Corporate Tax Subsidies, by Gregg A. Esenwein and Jane G.
Gravelle.

---

CRS-10
arguments incorporate increasing investor or consumer confidence, which suggests
a short-run stimulus objective.
An Overview of Economic Issues
The stock market is subject to fluctuations, but its value is also an important
price signal mediating between investors and firms. To undertake a permanent tax
change for the purpose of influencing the stock market price is an objective not easy
to justify — particularly since it cannot be done a second time. The principal
justification for focusing on this value is an expectation that the rise in the stock
market would spur spending in the short run.
Increases in stock market values are thought to increase spending through a
wealth effect, although both theory and empirical evidence suggest the wealth effect
on consumption is small.13 In theory, however, a rise in the stock market induced by
tax cuts reflects the windfall gains that accrue to investors who already hold an asset,
and arise from the need for time to adjust portfolios and capital stocks in response to
the tax change. The rise is simply a manifestation of part of the income effect that
should already be considered in evaluating any economic stimulus and therefore
should not be considered as having a separate stimulative effect on the economy
(unless investors are not rational). If adjustment were instantaneous, the stock
market’s value would never change, at least under traditional views of dividends.
The larger the stock market price effect, the smaller the economic efficiency benefits
to reallocating capital that are the principal justification for corporate tax integration.
Moreover, the rise in the stock market does not simply appear by magic — it
arises out of shifts in supply and demand as do any other prices in the economy. If
savings and portfolio allocations were fixed, no changes in the value of the stock
market would occur, and stockholders would simply earn a higher rate of return. If
the stock market does rise, it is also important to recognize the processes that lead to
that increase and their consequences for short-run effects on demand. Individuals
may be saving more (which is contractionary) or they may be shifting out of other
assets (which can be contractionary if coming from physical investment and raise
interest rates if coming from bonds). The rise in interest rates will contract
investment spending financed from debt. If corporate firms are to increase their
equity investment, they must either retain more earnings (which reduces dividends
available for other spending) or they must increase the supply of stock shares (by
issuing stock or reducing repurchases). This increase in stock shares will push stock
prices back down somewhat and the increase in investment will ultimately drive
down returns per share.
It is possible that a rise in the stock market could result in an increase in
business or consumer confidence that could separately produce an economic
stimulus. Some research in this area has suggested that such an effect on consumers
is not very likely, since the run up in the stock market in the 1990s seemed to
13 See James M. Poterba, “Stock Market Wealth and Consumption,” The Journal of
Economic Perspectives, vol. 14, spring 2000, pp. 99-118 for a review of the literature, which
suggests a dollar of wealth increases consumption by about 3 cents.

---

CRS-11
primarily manifest itself in the increased spending of higher income individuals who
own stock.14 Moreover, businesses, particularly sophisticated firms, would likely be
aware of the link between tax cuts and wealth. But, in any case, if there is a
relationship it presumably would depend on the magnitude of expected effects —
they should be large enough to at least attract attention. The remainder of this section
attempts to quantify the expected effect on the stock market to determine whether it
might be large enough to gain notice.
Perhaps the simplest way to explore this issue of the stock market effect is to
discuss the magnitude of potential effects that have been in the news and whether
those effects are reasonable and significant. This analysis will be followed by a brief
explanation and discussion of the implications of an alternative economic theory
about the effect on stock market prices — the trapped equity view.
Estimated Stock Market Effects: A Standard Analysis
When the dividend proposal was initially introduced, potential effects on the
stock market of up to 20%, which would be significant, were mentioned.15 Two
other estimates of the effect: one provided by the administration at 10%, and one
estimated by MIT economist James Poterba, of 5% to 6%, were reported in a Wall
Street Journal article16. (The proposal also includes reductions in capital gains taxes
on income retained in the firm). This section examines the value of 5%-6% proposed
by Poterba (where underlying data are presented to support the calculation). The
analysis suggests that this value is probably an upper limit to the effect, and the likely
effect would be much less, perhaps no more than 1% or 2%. Certainly, the effect is
likely to be small compared to normal fluctuations in market values.
There are no explanations of the source of the 10% estimate, but Poterba
provides the basics for his calculation, which is a very straightforward estimate of the
present value of the tax cut divided by the value of the stock market. His calculation
appears to be of the form:
% Change in Stock Value = Tax Cut
Discount
Stock Value
14 A recent study by Karen Dynan and Dean Maki, “Does Stock Market Wealth Matter for
Consumption?” as well as a study by Dean Maki and Michael Palumbo, “Distentangling the
Wealth Effect: A Cohort Analysis of Household Savings in the 1990s,” both in Finance and
Economics Discussion Papers, Board of Governors of the Federal Reserve, 2001-23, and
2001-21 respectively, found little or no relationship between stock market wealth and
consumption by those who did not own stock.
15 See “Can a Dividend Tax Cut Juice Growth,” Business Week Online, Jan. 3, 2003. The
20% number is attributed to Glenn Hubbard, then Chairman of the Council of Economic
Advisors, but that number probably reflects an analysis in an academic research article
reflecting the trapped equity, or “new view,” discussed in the next section. An estimate of
6% to 9% was also mentioned in the Jan. 3 article.
16 Bob Davis and Greg Ip, “The If Factor: Bush Stimulus Package Needs Many Assumptions
to Pan Out,” Wall Street Journal, Jan. 8, 2003, p.1.

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CRS-12
There are four issues that affect this percentage: the size of the tax cut, the
discount factor, the current value of the stock market, and whether the formula itself,
which reflects a full and permanent expected capitalization effect, is complete. We
consider each factor in turn.
Cost of the Tax Cut. Poterba reports the first year tax cut as $26 billion. The
Treasury estimate of the dividend tax proposal is $20 billion for 2003, according to
an Administration document issued on January 7, 2003. This number is, however,
somewhat understated for capitalizing over time because the proposal includes not
only dividend relief but also a basis adjustment that will reduce tax revenue later;
only a small share of this basis adjustment is included in the first year cost. There
may also be some slight difference because of accruals versus collections. To correct
for the first, the estimated costs would increase to about $25 billion were the full
effects of basis adjustment to be taken into account.17 Given there is some slight
discrepancy between accrual and collection basis that would also make the Treasury
number slightly too small, along with a small offsetting effect from the fact that the
first few years do not actually include the full effects of basis adjustment, Poterba’s
$26 billion number is a reasonable one.
Discount Factor. The annual revenue cost must be summed over all future
years and then discounted at some rate of return in order to create a present value.
Poterba estimates the present value of the stream of tax cuts to be $500 billion to
$650 billion. In a growing economy, one would normally think that dividends and
tax payments would grow at the growth rate of the economy as well as being
discounted at some after-tax equity return. Thus we can think of the discount factor
as being R - g, where R is the after tax required rate of return of the investor and g
is the growth rate. The difference between the two should also reflect the current after
tax earnings as a percentage of asset value. By working backward, we can determine
this discount factor to be 0.04 (26/650) and 0.052 (26/500). This range of values is
reasonable.18
17 Based on an average five-year holding period, the current year cost for the basis
adjustment’s effect on capital gains will be about a fifth of the long-run effect. However,
the capital gains tax is much lower than the dividend tax, so its importance is somewhat
diminished. Capital gains tax rates are around 18%. (Gains for those in the 15% bracket
are taxed at 10% if held for one year and 8% if held for five years; otherwise gains are taxed
at 20% if held for one year and 18% if held for 10 years.) If we cut the 18% rate in half to
account for the fact that about half of gains are never realized, and assume that the average
marginal tax rate on ordinary income is around 30%, the capital gains tax rate is about 30%
of the individual rate. With about half of earnings paid out as dividends, based on data for
the last few years, the permanent cost will bear the ratio of
(0.5X0.3+0.5)/(0.5X0.2X0.3+0.5), or 1.23. This ratio suggests a cost of $24.6 billion.
(Note: When calculating dividend payout shares from the National Income and Product
Accounts, it is important to subtract out from earnings and from dividends the significant
amount of dividends paid by Subchapter S corporations that do not pay the corporate tax.)
There may also be some slight difference because of accruals versus collections.
18 One can use either real or nominal values. With a 2.5% real growth rate, the 4% value
implies a real return of 6.5% and a nominal return of 8% with 2.5% inflation. The 5.2%
value implies a return of 7.7% real and 10.2% nominal return with 2.5% inflation.

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CRS-13
Stock Market Value. Estimates are sensitive to stock market value, which,
of course, fluctuates considerably. At close of business on January 15, the value was
estimated at $12.2 trillion,19 which leads to a range of percentage appreciation
derived from the tax cut of about 4.1% to 5.3% using Poterba’s method. Slightly
over a week later on January 24, it had fallen to about $11.6 trillion. Poterba appears
to be using a value of around $10 trillion to $11 trillion which is lower than these
values but reasonable given the market’s volatility.
In any case, a 5% to 6% stock market gain from the tax proposal is a relatively
small effect. For example, for the slightly over three-month period from the end of
September 2002 to mid-January 2003, the market rose by 12%, an effect over twice
the size of the estimated stock market effect of the dividend tax proposal. The
market fell by 5% from January 15 to January 24, a period of slightly over a week.
This effect is about the same size as Poterba’s estimated stock market effect and it
suggests that if Poterba’s calculation is correct, the increased value is unlikely to have
much effect on consumer or investor confidence.
Method of Calculation. The calculated effect is the equivalent of
permanently capitalizing the value of the tax cut in the market. But there are two
important reasons that this value is an upper limit.20
The first, and perhaps most important, is that the higher returns in the stock
market will attract money out of the bond market, and raise interest rates. (The
economic stimulus itself also increases interest rates by increasing the demand for
money.) This increase in interest rates will have two effects that tend to lower the
effect on the stock market. The most important is that the expected after tax return
that forms part of the discount factor is tied to interest rates and will rise. Even very
small increases could eliminate most of the expected rise in stock prices. For
example, a 10 basis point change in the interest rate, that increases it by 0.1%, would
reduce market values by 2 to 2.5%, and would offset about half the estimated rise in
value.21 A change of slightly over 20 basis points would eliminate the effect
completely even if this effect occurred only through the discount factor. The higher
19 This value is based on market value at the end of the 3rd quarter 2002 for the Nasdaq, New
York Stock Exchange and Amex: $1.717 trillion, $9.041 trillion and $0.094 trillion
respectively, or $10.8 trillion (see [http://marketdata.nasdaq.com/asp/sec1summary.asp]).
These values were updated for close of business January 15 using the Nasdaq, S&P 500 and
the AMEX composite (factors of 1.215, 1.122 and 1 respectively, see
[http://finance.yahoo.com/m1?u]; note that the NYSE composite was not used because it
has been recentered).
20 Under one theory about markets, mainly that dividend taxes in excess of capital gains
taxes, are capitalized into asset values, there is a permanent rise in the stock market from
repealing the dividend tax. This view, referred to as the “trapped equity view” and also the
“new view,’ (as opposed to the traditional view) suggests that dividend taxes do not matter
to investment behavior and will be discussed below.
21 The ratio of new to old market value is (R-g)(R-g+0.1), where R-g is the discount factor.
Thus the price falls by 2.5 % at 4% (1-.04/.041) and by 1.9% at 5.2% (1-.052/.053). This
calculation assumes an additive risk premium.

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CRS-14
interest rates will also, however, increase the cost of borrowing for firms and reduce
cash flow which would also act to reduce stock market values.
If the supply of savings is fixed (e.g. increased private savings does no more
than offset government borrowing to finance the tax cut), there is no new wealth in
the economy. In that case, asset prices in the economy will quickly return to their
equilibrium values. As soon as individuals make their portfolio shifts (out of bonds
and into stocks), which would presumably happen very quickly, the interest rate
would rise. Moreover, some effect on corporate cash flow would occur as borrowing
costs rose. The offsetting of the price effect would appear more quickly if
individuals are forward-looking and expect interest rates to rise. That is, if
individuals have foresight and expect interest rates to rise, they will take this
expectation into account and alter their own discount rate for valuing stock
immediately even before portfolio shifts are complete or all debt has turned over.
If the savings rate increases, there could be a longer adjustment period but the
rise in prices would be temporary. That is because added investment would
ultimately drive down the marginal return on capital. If individuals are myopic, there
could be a rise that will simply decline over time. But if investors are rational and
forward looking, the expected change itself would moderate the initial rise. The
Appendix shows how this adjustment process might occur when we hold the interest
rate fixed. If h is the fraction of the remaining difference between the new and old
values of the marginal product of capital that is made in each period, then the ratio
of the actual percentage change assuming forward looking investors to the change as
calculated above is discount/(discount+h) (as shown in the Appendix). In the case,
for example, where the dividend rate equals .04 and the fully capitalized effect is
5.3%, if h = 0.10, the actual effect will be only 1.5%. Since the effect of this change
on the desired capital stock and the desired marginal product of capital is only about
4 or 5%, this change is a small one that could be expected to be adjusted to quickly.
There is one offsetting factor that could lead to a small share of the market rise
being permanent: the possibility of permanent excess profits from market power. If
a firm is earning excess profits because it has market (or monopoly) power, that
effect would have been capitalized into a higher market value for stocks. To use an
extreme case, if every firm were a pure monopoly with demand characterized by a
linear demand curve, only half of a change in tax is passed on in price. Therefore,
one would expect that if the only adjustment that occurred was a change in the
marginal product of capital, half the rise in the stock market would be permanent and,
using the example in the previous paragraph, the initial effect might be a 3% increase
rather than a 1.5% increase. This effect is much too large, however. Some of the
adjustment is likely to take place in the discount rate in the denominator, which
exerts the same proportional effect regardless of market value. Pure (unregulated)
monopolies largely don’t exist in the United States, and the passthrough becomes
larger as the number of firms increase. Moreover, in oligopoly models of any size,
price competition (known as Bertrand competition) can lead to the same effects as
perfect competition. Thus, while the effects of market power are likely to slightly
increase the initial price effect because some effects are permanent, this effect is
probably quite small.

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CRS-15
The Trapped Equity or “New” View of Dividends
There is a theory, referred to as the “trapped equity” or “new” view (although
it is 25 years old) that suggests dividend taxes (in excess of capital gains taxes) are
irrelevant to investment behavior. The entire stream of dividend taxes in excess of
capital gains taxes under the proposal would show up as a windfall to current
stockholders. If one holds this view, the effects on the stock market should be larger.
However, there would be little efficiency gain from the reallocation of capital for
eliminating these taxes. Again, a belief in a large permanent effect on the stock
market is only consistent with a belief that there is little to gain in efficiency effects
from dividend tax relief. As this section suggests, however, even this analysis
suggests a stock market increase of only 3%.
For a tax that reduces both dividends and capital gains taxes, the portion that
reflects the excess of dividends over capital gains would be permanently capitalized.
Assuming a tax rate of 30% on dividends and 10% on capital gains, and about half
of income paid in each form, about half the tax cut would be permanently capitalized.
To understand how this theory developed and what it means, it helps to contrast it
with the traditional view, which underlies the analysis in the previous section.
In the traditional view of dividends the cost of capital is affected by both the
dividend and capital gains tax rates. The double tax on dividends causes
inefficiencies and misallocation of capital away from corporate equity investment.
In the new view, the dividend tax has no effect on investment (see Appendix for a
mathematical derivation of this effect).
In the traditional view, with perfect competition and without other tax subsidies,
the value of a dollar of equity owned capital is equal to a dollar of value in the stock
market. While stock market prices may rise initially, they will eventually return to
this equilibrium value as discussed above and expectations will limit the initial rise.
In the trapped equity view, dividend taxes (in excess of capital gains taxes), which
do not influence investment, are windfall losses to the individuals who own stock
when the dividend tax is imposed and are expressed in a permanent reduction in
stock price. Removal of those taxes would be a windfall loss to current owners.
(The actual supply and demand processes that accompany this effect are not clear.)
One of the issues that spurred the development of the trapped equity theory was
the fact that firms pay dividends, even though they are more heavily taxed than
capital gains. To explain why firms pay dividends, the traditional view of dividends
requires that dividends have some value or be differentiated in some way from capital
gains; otherwise firms would never pay dividends and would distribute excess
earnings by repurchasing stock. Several economic theories could motivate the
payment of dividends. The simplest is that dividend and capital gains income differ
in important ways (earnings from sales of assets fluctuate more and involve greater
transactions costs than the receipt of dividends). Economists have also advanced
notions dealing with imperfect information (dividends are a signal that the firm is
doing well) and principal agent problems (dividends keep managers from diverting
or wasting too much of the earnings).

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CRS-16
The original form of the trapped equity view was essentially an alternative way
of explaining why firms pay dividends. It is based on the notion that dividends are
trapped in the firm and that earnings cannot be paid out to the shareholder in any
other form, i.e. no share repurchases. The dividend tax must be paid now, or later
with interest, but cannot be avoided. The idea is much like an that associated with
an individual retirement account. The problem of double taxation is much less
severe because the cost of capital is affected only by the accrual equivalent capital
gains tax rate which tends to be small because of lower rates, deferral of tax, and
avoidance of tax if held until death.
Assuming financing via retained earnings, in the new view a dollar of equity
capital has a value (referred to as q) of (1-2)/(1-c), where 2 is the dividend tax rate
and c is the capital gain tax rate. This ratio occurs because the shareholder is
indifferent between receiving a dollar of dividends net of tax (that is the cost of
retaining earnings is (1-2)) and retaining it in the firm where its value is the increase
in value, or q, times (1-c), where c is the capital gains tax rate.
This formula may explain how some of the larger effects that might be expected
on stock market values might have been calculated if dividend relief was provided.
For example, if the dividend rate is 30% and the accrual equivalent capital gains tax
is 10% (an estimate that is consistent with evidence suggesting that close to half of
capital gains are never taxed), the value of the stock market is (1-0.3)/(1-0.1), or
$0.78 for each dollar of capital. Eliminating both taxes (or reducing the dividend tax
to 0.2) would permanently increase the value to $1 or almost 30% and thus it may
not be surprising if the finding of evidence for the new view in academic research
might have lead to the conclusion of a 20% stock market effect.
These estimates are, however, likely to be overstated, because a large fraction
of taxpayers (more than half) are not subject to taxes on dividends. If a weighted
average is used, the tax rates would be only about 40% as large, so the effect on the
stock market would be closer to 9% (rising from (1-0.4X0.3)/(1-0.4X0.1) or $0.917
to $1). In the actual proposal, of course, dividend taxes would not be eliminated but
would remain to the extent of preferences. If preferences reduce the tax cut by a
third, the new value would be (1-0.4X0.3X0.67)/(1-0.4X0.1X0.67) or $0.945,
implying only a 3% increase.
The trapped equity view, at least in its pure original form, has fallen out of favor
somewhat for theoretical reasons. One of the requirements for this pure form is that
firms not be able to repurchase their own shares, an option that has always been
available in the United States, and in fact has increasingly been used by firms.
Another is that firms do not issue shares and pay dividends simultaneously. The
traditional view can easily accommodate the repurchase of shares along with payment
of dividends, while modifications to the new view to make it consistent with
observed share repurchases may succeed in maintaining the view that dividends are
irrelevant to investment but tend to reduce the magnitude of the stock market effects.
One such approach is to make the dividend tax rate in the valuation formula a
weighted average of the dividend tax and the capital gains tax based on the ratios of
dividends paid to share repurchases although even this view requires a quite
restrictive assumption of a fixed proportion of repurchases and dividends. There are

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CRS-17
some other conceptual problems that arise with the trapped equity view as well as a
number of attempts to address the issue through empirical studies.22
Conclusion
None of the effects of the dividend tax relief proposal is likely to be large,
mainly because the tax cut itself, since it is restricted to individual taxes, does not
include tax exempt investors, and restricts benefits for preferentially treated income,
is not really that large. It amounts on average to about a one percentage point
reduction in the overall tax rate on capital income and about two percentage points
in reduction of the tax on corporate equity. As a short-term stimulus, either directly
or via stock market effects (which are themselves quite small), it is not clear that the
dividend relief is superior to other alternatives, while its long-run growth effects are
negative if it is deficit financed (and may be negative even if it is not). The principal
economic justification for the proposal is the economic efficiency gains from more
efficient allocation of capital.
22 For an earlier and non-mathematical survey of this issue, see George Zodrow, “On the
“Traditional” and “New” Views of Dividend Taxation, National Tax Journal, vol. 44, part
2, Dec. 1991, pp. 497. This paper suggests that the empirical work has not supported the
new view. Three recent papers are Trevor S. Harris, R. Glenn Hubbard, and Dean Kemsley,
“The Share Price Effects of Dividend Taxes and Tax Imputation Credits,” NBER Working
Paper 7445, Dec. 1999; Alan J. Auerbach and Kevin Hassett, “On the Marginal Source of
Investment Funds,” Journal of Public Economics, v. 87, Jan. 2003, pp. 205-232; and
Michelle Hanlon, James N. Myers, and Terry Shevlon, “Dividend Taxes and Firm
Valuation,” Working Paper, University of Washington, July 11, 2002. The first two of these
three more recent papers are new empirical studies, both providing some support for the new
view. The latter is essentially a criticism of the methods used in the first of the three papers,
but also contains a general review of the literature.

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CRS-18
Appendix
Growth Model
The growth model used to calculate the effect of dividend relief on future output
and the standard of living is composed of the following equations. The first is a
production function:
(1) Q = A[aK (1-1/S)+(1-a)L (1-1/S)] (1/(1-1/S))
t
t
t
where Q is output at time t, K is the capital stock at time t, L is the labor supply at
t
t
t
time t, S is the factor substitution elasticity, and A and a are constants.
The second is the equation for change in the capital stock letting all variables
be expressed in period 1 income levels:
(2) K
- K = s [ (Q -*K - t R K - t(Q -*K - R K )) - nK - D ]/(1+n)
t+1
t
t
t
t
k
t
t
t
t
t
t
t
t
where s is the savings rate out of disposable income, * is the economic depreciation
rate, t is the tax rate on capital income, R is the pretax rate of return to capital, t is
k
the tax rate on labor income, n is the growth rate of the economy, and D is the deficit
which is the sum of tax change and interest on the accumulated debt (pre-existing
debt and deficit are set to zero). Interest on the debt is the pretax return less a fixed
4% risk premiums, all multiplied by (1-t ) where t is the tax rate on government
g
interest payments.
The third is the equation for the savings rate:
(3) s = b(R (1-t ))E
t
t
k
where E is the savings elasticity and b is a constant.
Maximizing (1), subject to Q = (R +*)K + W L results in the first order
t
t
t
t
t
condition:
(4) R = a(Q /K )(1/S)A (1-1/S) - *
t
t
t
The model is calibrated to resemble the U.S. economy, with initial W and Q
normalized to 1, K set at 3.5, * set at 0.03, R set at .07, all initial tax rates set at 0.3,
and n set at 0.025. The budget constraint is used to calibrate labor supply, which is
thereafter set as a fixed amount (not sensitive to changes in the wage, which is a
reasonable representation of the labor supply literature).23 We do, however, explore
the effects of a labor supply response, using the additional labor supply formula:
(5) L = h(W (1-t))(
t
t
where h is a constant and ( is the labor supply elasticity.
23 Most evidence shows little or no response of labor supply to changes in the wage rate.

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CRS-19
We simulate the effects for a change similar in size to the proposed dividend
relief plan (determined by dividing initial revenue loss by output), reducing the tax
rate on capital by one percentage point.
For the discussion of using a larger versus marginal tax rate when considering
tax exempt investors, the savings equation in (2) above would be multiplied by a
term that is [(1-t )/(1-t )]E*, where a and m refer to average and marginal tax rates,
a
m
and E* to the substitution elasticity. The substitution elasticity would be the
observed elasticity plus the income elasticity.
In the case of international capital flows, the capital stock and output are fixed.
The deficit still accumulates and the effects on the standard of living are reflecting
in a reduction of income available to Americans because a share of the capital stock
is owned by foreigners. Where this return is subject to tax, some portion is available
because it is collected by the Treasury.
Adjustment and the Stock Market Value
This section discusses an approximation of the calculation of the effects if
expected adjustment in the stock market by forward looking investors. The effects
do not account for the possible speedup in capital gains taxes due to the rise and then
fall of the price, but this effect is likely to be small.
For investment purposes, one can solve for the marginal product of capital
through an equation for the present value of earnings on a dollar of investment:
4
(6) 1 = I {[MPK(1-µ)-(g+*) +:z(g+*)](1-2) - cg}e-(R-g) tdt + :z(1-2)
0
where MPK is the marginal product of capital, : is the corporate tax rate, * is the
economic depreciation rate, g is the growth rate, 2 is the dividend tax rate, R is the
after-tax discount rate, and c is the capital gains tax rate. Solving for MPK, and
assuming that economic depreciation is allowed, so that z = */(R+*)
(7) MPK = R - g(2-c)) +*
(1-2) 1-:)
To solve for the value of the firm per dollar of capital stock:
4
(8) V = I {[MPK(1-µ)-(g+*) +:D](1-2) - cg}e-(R-g) tdt
0
where V is the value of the firm and is the annual depreciation deduction. The
solution to the integral is {MPK(1-µ)-(g+*) +:D](1-2) - cg}/(R-g). Note, as

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CRS-20
discussed above, that an increase in R will reduce the value. In the steady state, and
assuming economic depreciation (D = *) then, by substituting (7) into (8), obtain V
=1.
Eliminating the capital gains tax and the dividend tax, the value of the firm is:
4
(9) V = I [MPK(1-µ)-(g+*) +:D]e-(R-g) tdt
0
If the marginal product of capital never changes (permanent capitalization), then
substituting (7) into (9):
(10) V = 1 + (2(R-g) +cg)
(1-2)

(R-g)
Allowing the marginal product to gradually fall to its new level:

(11) MPK* = (R- g) +*
(1-:)

Suppose the gap between old and new marginal product is expected to change at the
rate h. Then write the value as:
4
(12) V = I [(MPK* +(MPK-MPK*)e-ht(1-µ)-(g+*) +:D]e-(R-g) tdt
0
When t is zero, the marginal product is equal to MPK; as t goes to infinity, the
marginal product is equal to MPK*.
(13) V = 1 + (2(R-g) +cg)
(1-2)
(R+h-g)
Thus the ratio of change with the expectation of adjustment to the permanent
capitalization effect is (R-g)/(R+h-g). Note that we do not use (10) and (13) directly
to determine stock values for two reasons. First, we don’t have enough information
about the effective tax rate given that only part of dividends will be excluded because
of preference allocation and only part of dividends are now subject to tax. Second,
these formulas for stock market effects would be true only if the market is currently
experiencing an equilibrium long-run price level under current tax rules, an
assumption that cannot be made. By using ratios, the estimate can be made with
direct estimates of the value of taxes and the stock market.

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CRS-21
The Trapped Equity or New View of Dividends
Assuming financing via retained earnings, a dollar of equity capital has a value
of (1-2)/(1-c). This occurs because the shareholder is indifferent between receiving
a dollar of dividends net of tax (that is the cost of retaining earnings is (1-2)) and
retaining it in the firm where its value is the increase in value, or q, times (1-c),
where c is the capital gains tax rate. That is, in equilibrium
(14) (1-2) = q(1-c), and therefore q = (1-2)/(1-c)
The present value of earnings on a dollar of capital must equal q. Therefore:
4
(15) q = I{[MPK(1-µ)-(g+*) +:z(g+*)](1-2) - qcg}e-(R-g) tdt + :z(1-2)
0
and substituting in for the equilibrium value of q:
(16) MPK = R +*
(1-c)(1-:)
Only the capital gains tax rate appears in the marginal product of capital term.
Note that this model (as shown in equation (14)) implies perfect substitutability
between receiving earnings as a dividend and as a capital gain and dividends are paid
out only as a residual after all investment needs are satisfied. Note also that the
model no longer works if share repurchase is allowed as an alternative, which would
imply that the earnings of share repurchase,(1-c), equals the benefits of reinvestment,
q(1-c). In this case, q would have to equal 1. Moreover, no dividends would be paid.
To allow for simultaneous investment, share repurchase, and dividends a model that
provides imperfect substitutions between these choices or some additional benefit of
dividends or cost of share repurchases. One such theory consistent with a traditional
view is that dividends are differentiated from capital gains so that for the marginal
dollar the dividend (and its benefit) or the capital gains (and its cost) are equated.
Other theories have presupposed that there is a fixed share of dividends and retained
earnings (with all marginal adjustments made through share issues) which is
consistent with a traditional view, while another is that share repurchases and
dividends are made in fixed proportion (a theory consistent with a modified new
view where dividend taxes do not matter in the cost of capital and the value of 2 is
a weighted average of the dividend and capital gains tax). Why such choices should
be completely imperfect substitutes is not clear, however. Theories also suppose that
repurchasing shares is costly relative to paying dividends because of information
asymmetries which again would permit a modified new view.

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