A Two-Essay Dissertation Examining Individual Tax Reform and the Implied Cost of Equity Capital

Abstract

ESSAY 1: Prior studies of the Jobs and Growth Tax Relief Reconciliation Act of 2003, which cut individual tax rates on both dividends and capital gains, unexpectedly find that non-dividend firms were more favorably affected by this legislation than dividend firms. We address this apparent inconsistency by extending prior research to account for significant shifts in institutional holdings for non-dividend relative to dividend stocks following the tax change. These clientele shifts were especially concentrated among high book-to-market firms, and were large enough to result in observable reductions in the maximum aggregate tax burden on returns to equity for these firms. These results provide a plausible explanation for the results reported in prior literature and imply that the tax burden on returns to equity of the average investor may be as or more important in determining the cost of capital as the tax burden on the marginal investor.

ESSAY 2: Prior studies of the implied cost of equity capital investigate direct effects of individual dividend and capital gains tax rates on stock prices, but lack separate consideration of ordinary income tax rates, which have been altered with every adjustment of dividend tax rates in recent history and arguably restrict the supply of funds available for individual investment. Building on prior work demonstrating the indirect effects that changes in the tax cost of alternative income sources exert on security prices, I find over extended investment horizons that the implied cost of equity capital rises with ordinary income tax rates, consistent with a restricted capital supply. Furthermore, I find that the sensitivity of the implied cost of equity capital to changes in ordinary income tax rates is moderated by Treasury yields and multiple measures of risk, illustrating the link between equity risk compensation and the relative attractiveness of non-stock alternatives.

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