Capital Gains Taxation and Corporate Investment

Transcription

1 Uiversity of Chicago Law School Chicago Uboud Coase-Sador Workig Paper Series i Law ad Ecoomics Coase-Sador Istitute for Law ad Ecoomics 2016 Capital Gais Taxatio ad Corporate Ivestmet David A. Weisbach Follow this ad additioal works at: Part of the Law Commos Recommeded Citatio David A. Weisbach, "Capital Gais Taxatio ad Corporate Ivestmet" (Coase-Sador Workig Paper Series i Law ad Ecoomics No. 740, 2016). This Workig Paper is brought to you for free ad ope access by the Coase-Sador Istitute for Law ad Ecoomics at Chicago Uboud. It has bee accepted for iclusio i Coase-Sador Workig Paper Series i Law ad Ecoomics by a authorized admiistrator of Chicago Uboud. For more iformatio, please cotact uboud@law.uchicago.edu.

2 Capital Gais Taxatio ad Corporate Ivestmet David Weisbach The Uiversity of Chicago Jauary 12, 2016 Abstract This study examies the iteractio of divided taxes ad capital gais taxes o the sale of stock. Usig a model of the ew view of divided taxatio modified to icorporate realizatio-based capital gais ad losses o stock, it shows that there are two iteractios that effect the timig of divided paymets. First, there is a icetive to distribute divideds prior to realizig gai o a stock sale. Secod, the timig of divideds is affected by cosideratios parallel to the stadard locki effects for sales. Fially the paper shows that if there are tax clieteles, the ew view o loger holds. The coclusios have a umber of policy implicatios ad also may affect empirical strategies used to idetify the ew view. Keywords: divided taxatio, capital gais, ew view, lock-i Walter J. Blum Professor, The Uiversity of Chicago Law School ad Seior Fellow, Computatio Istitute ad Argoe Natioal Laboratories. I thak Ala Auerbach, Tom Brea, Dhammika Dharmapala, Mihir Desai, Daiel Hemel, Louis Kaplow, Al Warre, Day Yage, ad participats at workshops at Harvard, Staford ad UCLA for commets o earlier versios of this paper. Commets welcome. Sed to d-weisbach@uchicago.edu Electroic copy available at:

3 This paper examies the iteractio of divided taxatio, capital gais taxatio, ad corporate ivestmet. To motivate the problem, cosider the sale of the stock of a corporatio. Suppose the stock is worth $100, the seller has a basis of $40, ad the corporatio has divided payig capacity of $60. It will evetually pay $60 (or the future value of $60) as a divided. Compare what happes if the divided is paid after the sale of the stock to what happes if the divided is paid before the sale. Suppose the divided is paid after the sale. If the buyer pays $100 for the stock, the seller will recogize $60 of gai. Sometime after the sale, the corporatio will pay a divided with a preset value of $60. Because of the distributio, the value of the corporatio will go dow from $100 to $40. The buyer paid $100 for the compay which is ow worth $40, which meas that the buyer will have a $60 capital loss that he will get whe he sells the compay. The overall result is a capital gai of $60, a divided with a preset value of $60, ad a capital loss of $60, with the gai ad loss separated by time. The capital loss may also be subject to loss restrictios. Suppose istead that the corporatio pays the divided immediately before the sale. The seller will have a $60 divided ad o further gai or loss whe he sells the compay for $40. The buyer will ow a corporatio worth $40 which he purchased for $40 with o further gai or loss. The overall result is just the $60 divided without the imperfectly offsettig capital gais ad losses. Because payig the divided before the sale elimiates the capital gai ad loss, which do ot perfectly offset, the after-tax value of the stock is higher if the divided is paid prior to the sale, all else equal. That is, the iteractio of the divided ad capital gais tax rules geerates a icetive to accelerate divideds uder these circumstaces. Note also that if the divided is paid after a sale, the capital gai is taxed to oe taxpayer ad the divided ad loss to aother. This raises the possibility of clietele effects. For example, if the buyer ca exclude divided icome but claim the capital loss, there may be icetives to pay the divided after the sale rather tha before. The seller would have gai of $60, the buyer would have o divided icome, ad a loss of $60, which meas that there would be o et tax o the sale. Electroic copy available at:

4 Capital Gais Taxatio ad Corporate Ivestmet Page 2 Alterative tax treatmets of the buyer ad seller may create yet differet icetives. The icetive to accelerate (or possibly defer due to clietele effects) divideds arises because of the iteractio of divideds ad capital gais. Divideds reduce capital gais. Uder a realizatio-based system, the timig of both capital gais ad divideds are a choice, which meas that we have to cosider both together to uderstad the icetives they create. There are a large umber of studies of the effects of divided taxatio, such as ew view models based o Kig (1974), Auerbach (1979), ad Bradford (1981), ad traditioal view models such as Poterba ad Summers (1985). These models, however, either impose cotiuous mark-to-market taxatio o stock or igore the taxatio of stock gais altogether. With cotiuous mark-to-market, there is o poit i time after corporate gais are created ad before shareholders are taxed o the icrease i the value of their stock, ad, therefore, the icetive to pay divideds early to elimiate the gai is elimiated. With o taxatio of stock gais, the icetives are elimiated by assumptio. To study this problem, I add realizatio-based capital gais taxatio to a preexistig model of divided taxatio from Chetty ad Saez (2010), ad solve for the optimal timig of divided paymets ad stock sales. The model embeds the ew view i that i the absece of clieteles ad with o issuaces of ew equity, the divided tax rate does ot affect the timig of divideds. It exteds the ew view, however, to show that the iteractio of divideds ad capital gais taxes do. I establish three propositios. 1. Assumig stock will be sold, ad if there are o clietele effects, there is a icetive to pay divideds prior to the sale. 2. There is a lock-i effect for divideds that is parallel to the lock-i effect for sales geerally. The differeces i the two cases are that the basis recovery rules for divideds are less favorable tha for sales (icreasig the relative extet of lock-i) but corporate ivestmets are subject to the corporate tax (decreasig the relative lock-i). The et effect depeds o parameters. Electroic copy available at:

5 Capital Gais Taxatio ad Corporate Ivestmet Page 3 3. Clietele effects with realizatio-based capital gais may give rise to icetives to accelerate or delay divideds, depedig o the treatmet of gais, losses ad divideds of various shareholders. I particular, whe there are tax clieteles, the ew view o loger holds: the divided tax rate may create icetives to accelerate or defer divideds. After expadig o the motivatios for this study i part 1, the first two propositios are developed i separate models i parts 2 ad 3 respectively. Part 4 combies them ito a sigle model where the ower of stock ca receive a divided, sell a portio of his stock, ad retai a portio. This model shows the trade-off betwee divideds ad sales as well as the optimal timig of divideds. The two effects the icetive to pay a divided before a sale ad the icetive to defer divideds because of the lock-i effect work i opposite directios. Reducig the capital gais rate reduces the lock-i effect, so it may icrease divideds. At the same time, reducig the capital gais rate reduces the icetive to pay divideds prior to sales. Part 5 cosiders how these results may chage whe there are clietele effects. Part 6 cosiders implicatios. A key implicatio is that attempts to test whether the ew view holds based o divided tax cuts may ot be well idetified if capital gais rates are chaged at the same time. For example, the 2003 divided tax cut was accompaied by a chage i the capital gais tax rate as well as a complicated set of ati-arbitrage rules to miimize clietele effects. Because chages to the capital gais rates alter the icetives to pay divideds, idetifyig the effects of just the divided tax cut aloe may more difficult tha previously uderstood. Part 6 discusses this issue as well as the implicatios for corporate tax itegratio, divided tax reforms, ad the limits o the results. 1. Motivatios I have two motivatios for this study. The first was briefly described i the itroductio, which is that if divideds are paid after a sale, the et result is a capital gai, a divided, ad a offsettig capital loss, while if divideds are paid before a sale, the offsettig capital gais ad losses ca be elimiated. I illustrate this with a caoical legal case. The problem is quite geeral ad is subject to a

6 Capital Gais Taxatio ad Corporate Ivestmet Page 4 large amout of trasactioal plaig. Ad, ot surprisigly, there is a substatial body of law aimed at reducig the plaig. The caoical case is kow as Waterma Steamship v. Commissioer. 1 It is foud i essetially every corporate tax textbook, ad it is taught i stadard itroductory corporate tax classes i law schools. I Waterma, a compay kow as Waterma Steamship, owed a subsidiary, Pa-Atlatic Steamship (PAS). PAS had retaied earigs which it could pay as a divided although it did ot have readily available cash to distribute. Waterma had a basis i the stock of the PAS well below its value ad wated to sell it, miimizig the tax cost while doig so. Usig the umbers from the itroductio, suppose that Waterma had a basis i PAS of $40 whe its value was $100. Waterma agreed to sell the stock of PAS to a compay called MacLea Truckig. Rather tha a straight cash purchase of stock, however, Waterma ad Truckig arraged for PAS to distribute a ote with a face value of $60 as a divided immediately before the sale. (Thik of PAS as takig a piece of paper, drawig mermaids ad dragos i the corers, writig IOU $60 i the middle, sigig it ad distributig it to Waterma.) Uder the tax rules applicable at the time, the divided was tax-free to Waterma. The divided reduced the value of PAS to $40. Half a hour later, Waterma the sold the compay to Truckig for $40. Waterma had o further gai or loss because its basis was also $40. After waitig aother half hour, Truckig let $60 to PAS which it used to pay off its obligatio to Waterma. The Iteral Reveue Service argued that the iitial distributio of the ote was a sham because Truckig ultimately provided all of the cosideratio. Therefore, the Service argued, Waterma had sold PAS to Truckig for $100, which is equal to the $40 cash received from Truckig as sales proceeds ad the $60 cash received from Truckig idirectly via the ote. If Waterma had sold PAS for $100, it would have had gai of $60 o the sale rather tha a tax-free divided of $60. The court held for the govermet, treatig the trasactio as a sale of PAS for $ F.2d 1185 (5 th Cir. 1970).

7 Capital Gais Taxatio ad Corporate Ivestmet Page 5 Note, however, that PAS is oly worth $40 after all is said ad doe because it has $100 of assets ad owes Truckig $60. It started with a value of $100. It must have distributed $60 to someoe. The court held that it did ot distribute aythig to Waterma because Waterma received the $100 cosideratio from Truckig. PAS therefore must have distributed $60 to the oly other shareholder, Truckig, which makes sese because Truckig holds a $60 PAS ote. (Recall that the form of the trasactio was a loa by Truckig of $60 to PAS which meas Truckig got back a ote.) Therefore, uder the govermet s ad the court s versio of evets, Truckig paid $100 for PAS ad gets a $100 basis i the PAS stock. It immediately received a divided of $60, reducig the value of PAS $40. Because Truckig has a basis of $100 i stock worth $40, it will evetually have a capital loss of $60 but oly whe it sells PAS. Because it bought PAS to operate it as part of its busiess, the sale could be a log time i the future. Addig it up, there are three taxes uder this versio of evets: the $60 capital gai to Waterma, the $60 divided to Truckig, ad the $60 capital loss to Truckig. The capital gais ad losses, however, will ot offset because the capital loss to Truckig will be i the future ad possibly subject to loss limitatios. 2 The taxpayers would have bee better off if the divided came before the sale rather tha after, ad it is clear that they uderstood this because that is what they usuccessfully tried to do. I am by o meas the first to ote this problem. Not oly have tax plaers ad the govermet log uderstood the value of pre-sale divideds, as evideced by the Waterma case, at least a doze similar cases, ad umerous tax rules addressig these circumstaces, but there is a lie of literature (as far as I kow, exclusively i law jourals) discussig the problem (for example, Kigso (1976; Lag (1986); Levmore (1988)). Moreover, corporate tax reform proposals ofte iclude provisios to mitigate the problem. For example, the Treasury 2 If PAS liquidates ito Truckig, the loss will be elimiated. Eve if PAS is sold ad the usual capital loss limitatios do ot apply, there are a umber of other rules that may limit Truckig s ability to claim a loss o the sale of PAS (uder curret law, ot uder the law of the time). Most cetrally, the loss disallowace rules foud i Treasury regulatio may etirely disallow Truckig s loss.

8 Capital Gais Taxatio ad Corporate Ivestmet Page 6 Departmet, i its itegratio study (Departmet of the Treasury 1992), suggested allowig corporatios to declare divided reivestmet plas which are effectively a fictioal divided ad automatic reivestmet of the divided i ew shares. Uder the Treasury proposal Waterma could simply have declared a DRIP prior to the sale to get its desired result. The America Law Istitute i its itegratio study, made essetial the same suggestio. America Law Istitute (1993) Beyod Waterma ad related trasactios, my secod motivatio is to better uderstad the differece, if ay, betwee the ormal lock-i effect of capital gais taxatio ad the effects of divided taxatio. The ew view of divided taxatio says that a costat divided tax rate does ot affect the timig of divided paymets. It does ot, however, ecessarily say that the rules for divided taxatio, such as the basis recovery rules for divideds or the iteractio of divideds with the capital gais rules do ot geerate a equivalet to the locki effect for divideds. Because ew view models use either mark-to-market taxatio, or o taxatio, of stock gais, they caot, by costructio, capture potetial lock-i effects. The stadard ituitio for why the timig of divideds is uaffected by the divided tax rate is that divideds grow with time because the corporatio will ivest retaied earigs. Therefore, the preset value of divideds is costat, elimiatig ay icetive to defer or accelerate divided paymets. But the same thig happes with cash left i ay productive asset. Cash left i a productive asset is ivested ad will be expected to grow at the market rate of retur. Why is it thought that the preset value of the after-tax proceeds is costat i the case of divideds but ot for capital gais? To illustrate, suppose that a taxpayer holds a asset with a value of $100 ad basis of $0. If the taxpayer sells the asset ad reivests the proceeds, he must pay tax o the gai ad ca oly reivest the after-tax amout, while if he retais the asset, he ca ivest the full $100. The ivestmet of the tax that would be due o a sale is what geerates the lock-i effect. But the same is true if the asset is stock ad the choice is whether to receive a $100 divided ow ad reivest the aftertax proceeds or to leave the $100 i the corporatio. I both cases, the curret realizatio meas that the taxpayer ca oly ivest the after-tax amout ad the

9 Capital Gais Taxatio ad Corporate Ivestmet Page 7 deferred realizatio meas that the taxpayer ca ivest the pre-tax amout. Thus, my secod motivatio for this study is to uderstad whether divided taxatio is i fact differet tha the taxatio of other realizatios of gai. 2. Divided policy coditioal o realizatio of stock gai To study the iteractio of divideds ad capital gais, I modify the model of divided taxatio foud i Chetty ad Saez (2010). To isolate the problem, I igore the possibility of ew equity, ad, therefore, cosider a pure ew view model. Chetty ad Saez have o taxes o capital gais or losses i their model. I start with their presetatio before addig these taxes. Cosider a firm that has after-tax profits of X at time 0. The firm ca distribute D ow, ad will ivest the remaider, X D, distributig the aftercorporate-tax future value at time. The firm ca ivest at a pre-tax -period ' '' f x > 0, f x < 0. If the firm ivests X D, the after-tax amout retur of f, ( ) ( ) held by the firm i period is ( ) ( ) ( ) is the corporate tax rate. FV X D = 1 t f X D + X D, where tc c Followig Chetty ad Saez, let r be the required rate of retur o corporate ivestmets. Chetty ad Saez are ot explicit about whether this is a pre-tax or after-tax rate of retur, treatig it istead as a market-determied hurdle rate set by a uspecified margial ivestor. I the ext sectio, where I cosider the lock-i effect, r will be a pre-tax retur because I will be explicitly modelig capital gais taxes. For ow, we ca follow Chetty ad Saez ad view it was a uspecified hurdle rate. The preset value of the firm, V0, is the sum of curret distributios, afterdivided taxes, ad the preset value of the after-tax future distributios: (1) V = ( t ) D+ ( t ) ( ) ( 1+ r) FV X D d d where td is the divided tax rate. Note that because (1 td) appears i both terms o the right had side, we ca divide it through, ad thik of the value of the

10 Capital Gais Taxatio ad Corporate Ivestmet Page 8 corporatio as the preset value of the pre-tax cash flows grossed up by the divided tax. Takig the first order coditio with respect to D gives us the optimal divided policy. The firm should retai earigs so that its margial aftercorporate-tax retur equals the required hurdle rate: ' (2) FV ( X D) ( r ) = 1 +. The divided tax does ot affect the firm s ivestmet decisio, which is the essece of the ew view. To modify the model to iclude capital gais taxes, suppose that there is a sale immediately followig the period 0 divided. The seller will have a capital gai equal to the sales price (the seller s basis i the model is 0). The buyer gets a basis i the stock equal to the purchase price. Whe earigs are distributed i period, the buyer has a loss i a equal amout. The loss is realized at time m, whe the buyer sells the stock to yet aother party. 3 Lettig Q be the sales price of the stock, tg be the capital gais rate, ad tl be the tax rate applicable to capital losses, expressio (1) becomes: (3) V ( t ) D tq ( t ) ( ) L ( 1+ r) ( 1+ r) FV X D tq 0 = d g d m 3 I the simple model used here, a distributio of FV (X-D) effectively meas that the corporatio has liquidated. Uder curret rules, the buyer would be treated as havig the loss at that time (i period ). If the corporatio has activities or ivestmets other tha X, the corporatio ca cotiue ad the buyer would ot be give the loss util he sells the stock i period m.

11 Capital Gais Taxatio ad Corporate Ivestmet Page 9 The value of Q is the value of the corporatio immediately after the divided paymet: the after-tax preset discouted value of future cash flows ad the preset discouted value of the future capital loss: 4 (4) Q ( t ) Solvig, we get: (5) Q ( t ) ( ) LQ ( 1+ r) ( 1+ r) FV X D t = 1 +. d m FV ( X D) 1 = 1 d. t L ( 1 r ) 1 m + ( 1+ r) Substitutig (5) ito (3), the value of the corporatio is: (6) ( ) ( 1 t ) 1 d FV ( X D) t g V0 = 1 td D+. tl ( 1+ r ) 1 m ( 1+ r) Comparig equatio (6) to equatio (1), we ca see that the beefit of retaiig earigs is reduced by the term i the brackets o the right had side. Its value goes dow as m, (the time util the loss is realized), goes up ad as the effective tax rate o losses goes dow. To determie the optimal divided policy, take the first order coditio with respect to D to get: (7) ' FV ( X D) = ( + r) tl 1 m ( 1+ r) 1. 1 tg 4 Note that because of the tax disadvatages of a sale, the buyer will have to value the corporatio more tha the seller. There are a variety of reasos this might be so. For example, the seller might eed liquidity, might wat to rebalace his portfolio, or might have a differet expectatio of the value of FV tha the buyer.

12 Capital Gais Taxatio ad Corporate Ivestmet Page 10 Equatio (7) differs from equatio (2) by the last term i brackets. This term is due to the preset value differece betwee the tax o the gai ad the offsettig loss whe earigs are retaied. Uless m = 0 ad tl = tg, its value is greater tha oe, which meas that the margial rate of retur for retaied earigs has to be higher tha otherwise. As a result, the corporatio distributes more i the first time period. Distributios go up as the tax rate o losses, tl, goes dow ad as the time util the loss, m, gets loger. The higher the capital gais tax rate, the greater the effect. To see this, differetiate (7) with respect to the capital gais rate. Let the capital gais ad loss rates be the same, (deotig both tg) to get: (8) ` m FV ( X D ) m ( 1+ r) 1 = ( 1 + r). 2 t g ( 1 tg ) This is positive (ad i fact icreasig with tg): As the capital gais tax gets higher, the required margial retur for a corporatio to retai earigs goes up. Note that the divided tax rate does ot appear i (7). Cosistet with the ew view, the divided tax rate does ot matter. Istead, what geerates the icetive to accelerate divideds is the set of rules goverig iteractio betwee divideds ad capital gais. Oe way uderstad (7) is to ote that the capital loss tax rate that produces efficiet corporate ivestmet (margial returs equal to (1+r) ) is t = t ( + r) l g m 1. Tax losses would have to appreciate with time, which would effectively create a cash flow tax. That is, we ca, i part, thik of the timig effect i (7) is a geeric feature of icome taxatio as compared to cash flow taxatio. What is ew here is that size of the offsettig gais ad losses ad the timig of the loss deped o the timig of divided paymets, geeratig a icetive to accelerate divideds. Fially, ote that allowig the origial shareholder to have basis i his stock does ot chage the results. To see this, suppose that the origial shareholder has a basis B i the stock. I equatio (3), his gai becomes tg(q-b), so the oly

13 Capital Gais Taxatio ad Corporate Ivestmet Page 11 chage is a additioal term, tgb. This term falls out of the first order coditio, so there are o chages to the corporatio s divided policy. The reaso basis does ot matter i the model is that the taxpayer has bee give o choices that affect whe basis is recovered due to the assumptio that immediately after the iitial divided, there is a sale. The divided does ot affect basis ad the assumed sale uses up all of the basis. With these assumptios, the oly behavioral effect would be if the divided were large eough to create a loss ad the tax rate o losses was less tha the tax rate o gais. I that evet, the taxpayer ad corporatio would have a icetive to reduce divideds to avoid geeratig losses. The ext two sectios relax the assumptio that the stock will be sold. 3. Divided policy ad lock-i The discussio above cosidered the timig of divided paymets coditioal o realizatio. I the ext two sectios, I cosider the choice of whe shareholders realize icome, comparig sales to divideds. The lock-i effect of capital gais taxes o sales is widely ackowledged. If there is o parallel icetive to alter the timig of divideds, there is a puzzle as to why the tax system has differet effects o differet methods of realizig what is effectively the same ecoomic icome. It is helpful to have a simple model of the lock-i effect to compare to the model of divided taxatio. Suppose a ivestor ows a asset with a value of X ad a basis of B X (so that there is gai, potetially geeratig lock-i). If he holds the asset, he will get a retur of FV(X) i years. The asset might have some taxes o iterim returs, which I will assume are embedded i FV i the same way that the term icludes the corporate tax i the corporate cotext. I particular, the asset might be stock, i which case the retur is et of corporate taxes. I will explicitly cosider oly the capital gais tax o ay remaiig returs, imposed whe there is a sale. At time 0, the ivestor ca sell a fractio of his holdigs s 1 ad reivest the after-tax proceeds i asset 2 which ears a pretax retur of r. Asset 2, I will assume (but relax later) is subject to capital gais tax o the retur as of period but is ot subject to taxes o icreases i value durig the period it is held. It

14 Capital Gais Taxatio ad Corporate Ivestmet Page 12 could, for example, be a share of stock, udeveloped lad, mierals left i the groud, or a collectible. 1 g g If the ivestor sells a fractio s, he will have ( ) sx t + t SB after payig tax o capital gais o the sale ad recoverig a fractio of basis sb. I periods, this will be worth the pre-tax retur less capital gais taxes o that retur: (9) ( ) ( ) ( sx tg + tgb) ( + r) tg (( + r) ) The fractio (1-s)X which is held will be worth ( ) ( 1 )( 1 ) + ( 1 ) FV s X t t s B g g i period after payig capital gais taxes. The total value is the sum of these two amouts. It is coveiet to work with the future value of the portfolio, which I deote by V. (10) ( ( )) ( ) ( ( ) ) ( ) ( ) ( )( ) ( ) V = sx 1 t + t sb 1+ r t 1+ r 1 + FV 1 s X 1 t + t 1 s B. g g g g g The idividual should sell a fractio to maximize the after-tax future value. Settig the first order coditio with respect to s to zero, we get: (11) ( ) ( ) B FV ( 1 s X ) = ( 1+ r) tg 1 ( 1+ r) 1. X Beefit of deferral The first term o the right had side is the pre-tax retur. This is reduced by the secod term, which represets the beefit of deferrig the tax o built-i gais. If B = X, there are o built-i gais ad there is o deferral beefit. The ivestor compares the retur o the origial asset (adjusted for taxes, if ay, o that retur embedded i FV) to the pre-tax retur o the alterative ivestmet. I particular, if the both assets are pure capital gais assets, the ivestor simply compares pre-tax returs. As B goes dow so that there is built-i gai, the beefit of deferral goes up, which meas that the required margial retur for retaiig

15 Capital Gais Taxatio ad Corporate Ivestmet Page 13 the origial asset goes dow. The ivestor will therefore retai more ad sell less whe there is more built-i gai, which is the essece of the lock-i effect. Apply this setup to a corporatio that has X i after-tax proceeds ad ca pay a divided of D. Like above, assume that the shareholder has basis B i his stock ad that the shareholder reivests ay divideds i a asset that has a pre-tax retur of r which is subject oly to capital gais taxes. A importat differece betwee the taxatio of divideds ad asset sales is that whe a shareholder receives a divided, the shareholder may ot recover basis eve though he has realized a fractio of his value. The taxable portio of a divided is measured by corporate earigs, ot shareholder gai. This meas that eve if the shareholder has basis B i the stock, the etire distributio D is taxed. To write dow a expressio for the after-tax value, we eed to set a time for basis recovery. For simplicity, assume that immediately followig the fial distributio of the future value of retaied earigs, the shareholder sells his stock ad uses all of this basis, thereby gaiig value of tlb i period. With this assumptio, the value as of time is: (12) ( ) ( ) ( ) ( ( )) ( ) ( ) V = D 1 t 1 + r t 1 + r t FV X D + t B. d g d L Settig the first order coditio with respect to D to zero, we get ( ) = (13) FV ( X D) ( r) t ( r) There are two differeces betwee equatio (13) for divideds ad equatio (11) for sales. First, the divided expressio does ot iclude a term for basis recovery. It is the same as (11) settig B = 0. This is because of the ufavorable basis rules for divideds as compared to sales. The ufavorable basis rule lowers the required margial retur for a divided, creatig a icetive to defer divideds. ' Secod, FV ( X D) g icludes corporate taxes i equatio (13) but eed ot i equatio (11) depedig o what the origial asset is. The higher the corporate tax, the lower this retur (holdig the ivestmet fixed), icreasig the icetive

16 Capital Gais Taxatio ad Corporate Ivestmet Page 14 to pay divideds early. The et effect could go either way, depedig o the size of the parameters. Note that if the asset is a share of stock, the tax o oside build-up would be the same i both cases. Several commets are i order. First, the coclusios here are cosistet with the ew view because the divided tax rate does ot affect the timig of divided paymets. Oe must be cautious i iterpretig the ew view, however, i that other aspects of divided taxatio (as well as the corporate tax rate), do. I particular, the rules goverig basis recovery for divideds will affect the timig of divided paymets so we caot say that divided taxatio as a whole has o effect o the timig of divideds. A alterative basis rule for divideds, explored i Yale (2009), would treat all divideds as partial redemptios of stock, allowig taxpayers to recover a pro rata portio of their basis. This rule might be a improvemet to curret law, although give the ucertai directio of equatio (13), whether it is a improvemet might deped o the relevat parameters. Secod, that a low corporate tax rate creates a icetive to retai earigs is familiar. If the corporate rate is well below the idividual rate, a corporatio acts as a sort of IRA by allowig low-tax iside build-up. The persoal holdig compay tax is desiged to limit this. O the other had, if we compare a ivestmet i a pure capital gais asset which gets tax-free iside-build up to ivestig i a corporatio with a zero corporate tax rate, we ca see from the differece betwee (13) to (11) that the corporate ivestmet is worse due to the lack of basis recovery o ay iterim returs. Fially, the assumptio that sale or divided proceeds are reivested i a asset subject oly to capital gais taxatio was restrictive. Suppose that the proceeds are reivested i a asset subject to aual taxes o returs at the ordiary icome tax rate ti. Usig the same aalysis as above, cosider a ivestor with a asset valued at X ad basis B. The first order coditio for sellig a fractio s is

17 Capital Gais Taxatio ad Corporate Ivestmet Page 15 ( ) 1 = t B tg X + after-tax retur ' g (14) FV (( s) X) ( r( ti) ) ( r( ti) ) value of basis recovery The first term o the right had side is a after-tax retur, ot coutig basis recovery. That is, if the basis i the origial asset were zero, the hurdle rate for the ivestor would be the after-tax retur o the ew asset. The secod term o the right had side represets the beefit of basis recovery for the time period of the ivestmet, which reduces the lock-i. If we istead cosider divided distributios (ad like above, basis is recovered i period ), the first order coditio becomes ' (15) ( ) ( 1 ) = ( 1+ ( 1 i) ) FV D X r t The differeces i these two expressios is agai the beefit of earlier basis recovery for a sale relative to a divided ad the corporate tax o proceeds left i the corporatio. Agai, there could be a icetive to distribute or to retai earigs relative to the lock-i effect o sales, depedig o parameters. If the corporate rate ad the idividual rate were the same, equatio (15) tells us to ivest where there is the highest after-tax retur, which idicates that if reivestmets are i assets subject to taxatio o all iterim returs, the basis recover rules for divideds do ot geerate iefficiecies. Oe way to summarize this discussio is that the required rate of retur o alterative ivestmets the hurdle rate varies depedig o how the alterative ivestmet is taxed, the ivestor s basis i the origial ivestmet, how that basis is taxed, ad how iterim returs are taxed o the origial ivestmet. The ew view shows that the divided tax rate does ot affect the hurdle rate but divided paymets o stock are otherwise subject to the same forces that geerate lock-i or lock-out for other ivestmets or ways of realizig icome. 4. Combied model The above sectios establish first two results of this paper:

18 Capital Gais Taxatio ad Corporate Ivestmet Page 16 (1) To reduce imperfectly offsettig capital gais ad losses that result from a sale, there is a icetive to distribute earlier; ad (2) Effects parallel to the lock-i effect o sales apply to the divideds. The lock-i may be greater tha or less tha for sales, depedig o parameters. We ca combie these two ito a sigle model that shows the overall set of trade-offs. Suppose a shareholder ows stock with after-tax corporate earigs of X. For simplicity, assume the shareholder has a zero basis i the stock. The shareholder ca get a divided of D, sell a fractio s after the divided, ad retai the rest. The future value is: (16) V ( 1 t ) d * FV ( X D) 1 t * g = D ( 1+ r ) + ( 1 s) FV ( X D) + s ( 1+ r ). tl ( 1+ r) 1 m reivested divided retaied stock ( 1+ r) reivested sales proceeds where r * is the after-tax rate of retur available to the ivestor. If the ivestmet produces oly capital gais, the value of r * will produce a result that solves ( ) * ( r ) ( r) tg ( r) 1+ = If the ivestmet produces ordiary icome, the value of r * * is ( r ) ( r( t i )) 1+ = If the asset produces a mix, the aftertax retur will reflect that mix. Followig Chetty ad Saez, I use a uspecified r (ot the after-tax retur r * ) as the retur used to value the stock because the stock value is based o what a third party will pay. This will be a equilibrium rate which might be at or close to the pre-tax rate or the after-tax rate, depedig o the idetity of the margial ivestor. To determie the shareholder s desired choices, take first order coditios with respect to D ad s. For D we have: (17) ( ) ( )( ) * ( r ) V 1+ 1 t = + L D ( 1+ r ) 1 ( 1+ r) ( ) * ' g ' 1 r FV X D 1 s s FV X D. t m

19 Capital Gais Taxatio ad Corporate Ivestmet Page 17 Settig this equal to zero ad rearragig gives: (18) ( ) ( ) * ( r ) 1+ 1 t FV X D 1 s + s = 1 + r. L ( 1+ r ) 1 ( 1+ r) ( ) ' g * t m If s = 0, the (18) is just the lock-i rule, (equatio (13)). If s = 1, the (18) is the divided rule, (equatio (7)), but usig the after-tax discout rate applicable to capital gais. For 0 < s < 1, the term i the brackets will be less tha oe uless r * is substatially greater tha r, which meas the shareholder will wat the corporatio to distribute more ad have higher margial returs to corporate ivestmet. Said aother way, if you are goig to sell some stock (s > 0), you wat to icrease distributios. The reaso is due to the timig ad rate differetials for capital gais ad losses. The key the is determiig the optimal fractio s to sell. Withi this model, however, the taxpayer will wat to sell all of his stock or oe. To see this, take the first order coditio with respect to s: V s (19) ( ) ( ) * ( 1 r ) 1 t + g = 1 td FV X D ( 1 t ) ( ). tl d FV X D 1 m ( 1 ) ( 1+ r + r ) Settig this equal to zero, ad cacellig, we get: (20) ( 1 r )? * 1 t + g 1. tl 1 m ( 1 ) ( 1+ r + r ) This will be either less tha or greater tha zero depedig o the available aftertax returs to the ivestor, the values of, m, tg, ad tl. He will, at each poit i time, either sell all or sell oe because the alterative asset will have either a higher retur or a lower retur tha the stock. 5 The first term i the square 5 To avoid this corer solutio, we could allow the ivestor to have decliig margial returs to ivestig elsewhere. Itroducig this complicatio, however, requires much stroger

20 Capital Gais Taxatio ad Corporate Ivestmet Page 18 brackets represets the ot perfectly-offsettig capital gais ad losses that arise from a sale. The secod term, i the rouded brackets, is the lock-i effect, represeted by r *. 5. Clieteles Neither stadard models of the ew view or the models preseted above iclude clietele effects. Divideds ad capital gais tax rates, however, vary widely depedig o the type of taxpayer. I practice, we see trasactios desiged to take advatage of these effects. For example, i a trasactio kow as divided strippig, idividuals sell stock to corporatios cum divided ad the corporatio sells the stock back ex divided. The idividual will have capital gai, the corporatio excludes the divided (because of the divideds received deductio) ad gets a capital loss. The et result is to elimiate the tax o the divided that the idividual shareholder would otherwise pay. There are rules to prevet this simple versio of the trasactio but more sophisticated versios may still occur (ad there are yet more rules to prevet the more sophisticated versios ad ways to avoid these rules, ad so forth ad so o.) To uderstad how clieteles chage the coclusios, we ca modify the equatios to allow the buyer or seller to be subject to separate tax rates. There are at least three importat clieteles withi the set of domestic ivestors: idividuals (taxed o divideds, gais ad losses), corporatios (divideds are tax free but taxed o gais ad losses) ad tax-exempts (o taxes). Cosiderig just three clieteles, there are ie possible patters. Addig foreig ivestors (divideds are taxed, sales are exempt), fiacial istitutios (everythig marked to market assumptios regardig ivestmet decisios. It would, i additio, mea that the ew view o loger holds. To see this, suppose that i the basic model from part 2, alterative ivestmets have decliig margial returs. This might occur because alterative ivestmets are used to diversify the shareholder s portfolio ad the margial value of diversificatio goes dow rapidly with the size of the portfolio. We would the replace the fixed retur i equatio 1 with a variable retur h((1 t d)d) with h`>0, h``<0. The first order coditios of equatio 1 becomes ' h( ( 1 t ) D) = FV ( X D). The ew view does ot hold i this case because the divided tax d rate affects the timig of divideds. As the divided tax rate goes up, the corporatio will retai more.

21 Capital Gais Taxatio ad Corporate Ivestmet Page 19 ad taxed as ordiary icome) or other clieteles would create yet more possibilities. To keep the presetatio maageable, I will show the results for just three of the may combiatios. What is clear from just these examples is that addig clieteles to the model ca substatially alter the coclusios. Idividual to corporatio (divided capture case): The divided capture strategy discussed above ivolved a idividual owig the stock, sellig it a corporatio, a divided paymet, ad the corporatio the sellig it back to realize a capital loss. The idividual ad corporatio are taxed o the stock sales but the corporatio is ot taxed o the divided. Because the idividual gai ad corporate loss are realized at effectively the same time, we ca take these out of the equatio (uder the simplifyig assumptio that they are taxed at the same rate). The value i this case becomes: (21) ( ) FV ( X D) V = 1 t D+. 0 d ( 1+ r) Settig the first order coditio to zero produces: ' (22) FV ( X D) = ( 1 t )( 1+ r) Cotrary to the ew view results, the desired corporatio retur is reduced by the divided tax rate: as divided taxes go up, margial corporate returs go dow, which traslates to icreased retetios ad lower divideds. Idividual to tax-exempt: Suppose istead that the idividual sells the stock to a tax exempt. I this case, the idividual is taxed o the gais but the tax exempt will ot be able to claim the future offsettig loss, ad is also ot taxed o the divided. If the tax-exempt is the margial ivestor, the value of the corporatio at the time of the sale, Q, is simply the preset value of the cash flows, ot reduced by taxes (other tha the iteral corporate icome tax). Therefore: (23) V = ( t ) D+ ( t ) d ( ) ( 1+ r) FV X D d g

22 Capital Gais Taxatio ad Corporate Ivestmet Page 20 The first order coditio gives us: (24) ( ) ' 1 ( t ) FV X D = 1 + r. d ( ) ( ) 1 tg The divided tax rate agai affects divided paymets but the advatage of retaiig earigs is ow offset by the cost of the resultig capital gais taxes. If the divided tax rate equals the capital gais rate, the two cacel, but oly uder the assumptio that they come at effectively the same time (as assumed i (23)). Tax-exempt seller to idividual buyer. As a fial case, suppose that the origial holder of the stock is tax-exempt ad it sells the stock to a idividual. The tax-exempt pays either a divided tax or a capital gais tax while the idividual buyer pays tax o the divided ad ca claim the capital loss. The resultig value is: (25) V 0 = D+ ( 1 td) FV( X D) 1 tl ( 1+ r ) 1 ( 1+ r) m. First order coditios give: ' (26) FV ( X D) ( m ) ( 1+ r) tl ( ) ( 1+ r 1 t ) = 1. Ulike i the divided capture case, divided taxes here icrease the required margial rate of retur ad, therefore, reduce retetios. The reaso is that divideds are tax-free if paid while the tax-exempt holds the stock. This effect is offset, however, by the capital loss that the idividual buyer ca claim. As ca be see by examiig just these three cases, the presece of tax clieteles ca sigificatly chage the results ad ca do so i a variety of directios depedig o what types of taxpayers are ivolved. I should, however, stress that the results preseted i this sectio do ot accout for the wide variety of tax rules that gover trasactios desiged to prevet trasactios structured to take advatage of clietele effects. d

23 Capital Gais Taxatio ad Corporate Ivestmet Page Remarks 1. Idetificatio of tax effects of divided tax cuts. There have bee umerous attempts to examie the extet to which the ew view of divided taxatio holds. The ew view, umodified by the cosideratios aalyzed here, is thought to have two implicatios for divided tax policy. First, a permaet reductio i the divided tax rate should have o effect o divided paymets, ad secod, the divided tax rate should be capitalized ito firm value. Studies ofte use chages i the divided tax rate, such as the 2003 tax cuts i the Jobs Growth ad Tax Relief Recociliatio Act, to examie these effects. Bloui, Raedy, ad Shackelford (2011); Chetty ad Saez (2005); Brow, Liag, ad Weisbeer (2007); Auerbach ad Hassett (2006); Auerbach ad Hassett (2007). If the capital gais rate is chaged simultaeously with the divided tax rate, the cosideratios aalyzed here may alter both effects. With respect to the timig of divided paymets, lowerig the capital gais rate (ad implicitly the capital loss rate) will reduce the icetive to accelerate divideds see i Part 2. Payig a divided before a capital gai has less value if the tax cost of the capital gai is lower. Lowerig the capital gais rate will also reduce the lock-i effect o divideds see i Part 3. Depedig o the situatio of shareholders, either oe could domiate. With respect to firm valuatio, the secod predictio, i the models used here, the divided tax is still capitalized ito firm value, as see i equatio (6) but firm value is also effected by the capital gais rate (the right had bracketed term i that equatio). Lowerig the capital gais rate will make that fractio closer to oe. Therefore, firm value would be icreased by both the reductio i the divided tax rate ad by the reductio i the capital gais tax rate, potetially cofoudig a measuremet of the effect of divided tax cuts. Fially, the clietele effects see i part 5 may strogly affect the icetive to pay divideds ad may chage with the divided tax rate. Ay idetificatio strategy has to make a assumptio about the extet of these effects. The extet that these effects udermie the idetificatio strategy i ay idividual study will deped o the particular strategy used, the size of the capital

24 Capital Gais Taxatio ad Corporate Ivestmet Page 22 gais tax rate chages relative to the divided tax rate chages, assumptios about the tax treatmet of the margial ivestor, ad which of the effects is estimated. Nevertheless, because capital gais rates are ofte chaged at the same time as divided tax rates, cautio must be exercised. 2. Corporate Tax Itegratio The major policy implicatio of the ew view regards corporate itegratio, which is geerally iterpreted to mea reducig the tax rate o divideds to zero or ear zero. To the extet the ew view holds, so that firms fiace themselves with retaied earigs, corporate itegratio acts as a lump sum subsidy. Lowerig the divided tax rate would still, however, have efficiecy effects for ew equity. Oe possibility, therefore, is to limit itegratio to ew equity, as explored i America Law Istitute (1982). Itegratio for all equity would be premised o the view that distiguishig ew equity from existig equity is too difficult ad that the efficiecy gais for ew equity outweigh the costs of the lump sum subsidy for existig equity. Auerbach (2002, ) The cosideratios aalyzed here do ot address corporate itegratio geerally. By ot icludig the possibility of ew equity, I restricted the model to the ew view, ad, therefore, did ot address the key cosideratio for corporate itegratio. Nevertheless, as oted i Part 1, a umber of itegratio studies, icludig Departmet of the Treasury (1992) ad America Law Istitute (1993) iclude proposals to address the iteractio of divideds ad capital gais. Both the Treasury ad ALI would allow corporatios to elect to be treated as payig a divided that is immediately reivested by the shareholder (which the Treasury calls a divided reivestmet pla or DRIP). The effect is a immediate divided (ad ay resultig tax) ad a basis icrease i the shareholder s stock, thereby elimiatig the o-offsettig capital gais ad losses aalyzed i Part 2. The aalysis here suggests that proposals to allow DRIPs may be worth cosideratio, but that they are largely urelated to cuts i the divided tax rate or corporate tax itegratio. The icetive to distribute prior to a sale is based o the relative capital gai ad loss tax rates ad the timig differece betwee whe the gais ad losses will be realized. It arises regardless of the divided tax rate, as ca be see i equatio (7). That is, it seems apparet that the iclusio of DRIPs

25 Capital Gais Taxatio ad Corporate Ivestmet Page 23 i itegratio plas is at least partially premised o the idea that the zero tax rate o divideds is what makes DRIPs attractive to shareholders. I fact, the beefit of a DRIP is urelated to the divided tax rate. 3. Public Tradig A substatial portio of the stock of US compaies is publicly traded. To the extet that shares chage hads rapidly, some of the cosideratios here may be muted. I particular, to the extet shares are traded rapidly, it may ot be possible to distribute divideds prior to the realizatio of sigificat capital gais. Moreover, the time util the correspodig losses are realized may be relatively short. Nevertheless, public tradig will ot elimiate, ad may ot eve substatially reduce, the icetives explored here. Publicly-held compaies ted to have large block shareholders. For example, Holderess (2009) reports that of a represetative sample of publicly traded firms, block shareholders o average ow 39% of the commo stock. Ad eve smaller shareholders may ivest i public compaies over log periods of time. As a result, the icetives modeled here may well apply to a large umber of shareholders of public firms. To the extet these shareholders are the margial shareholders, the icetives cosidered here apply fully. 7. Coclusios The aalysis suggests care is eeded whe iterpretig the ew view of divided taxatio. The ew view holds that the divided tax rate itself does ot affect the timig of divideds. Withi the basic model cosidered here (without tax clieteles), this is true but there is evertheless, there may be icetives to defer or accelerate divideds because of taxes, icludig the basis recovery rules for divided. As a result, care is also eeded i idetifyig the effects of the ew view if chages to the divided tax rules are accompaied by chages to the capital gais tax rules. Clietele effects cofoud the aalysis further. Depedig o the tax treatmet of the buyer ad seller of stock, the divided tax rate may affect the timig of divideds, sometimes creatig a icetive to accelerate divideds ad sometimes creatig a icetive to defer them.

26 Capital Gais Taxatio ad Corporate Ivestmet Page 24 The aalysis here poits i a umber of directios. Oe is more careful cosideratio of how tax clieteles affect divided policy. If divided taxes are miimized by tradig amog clieteles aroud divided dates, perhaps the timig of divideds matters less tha their predictability so that trades ca be plaed. Corporatios ofte pay divideds regularly. Some have suggested that the reaso could be sigalig. A alterative explaatio could be tax effects. More geerally, more detailed aalysis of clietele effects o divideds seems warrated give the prelimiary remarks i part 5. Aother directio is to cosider how the divided tax rules might be reformed (icludig but ot limited to the applicable tax rate). The divided tax rules right ow are i a state of flux because they were desiged at a time whe divideds were taxed as ordiary icome but share repurchases were taxed as capital gais. Their core feature is a set of rules that distiguish divideds from share repurchases. With divideds ow taxed at the capital gais rate, these rules are less ecessary. Ad as oted, treatig divideds as partial repurchases reduces the lock-i effect to the extet of basis. Therefore, recosideratio of the rules goverig divided taxatio may be warrated.

27 Capital Gais Taxatio ad Corporate Ivestmet Page 25 Refereces America Law Istitute Federal Icome Tax Project Subchapter C: Proposals o Corporate Acquisitios ad Distributios ad Reporter s Study o Corporatio Distributios. Philadelphia, PA: America Law Istitute Federal Icome Tax Project: Itegratio of the Idividual ad Corporate Icome Taxes, Reporter s Study of Corporate Tax Itegratio. Philadelphia, PA: America Law Istitute. Auerbach, Ala, ad Kevi A. Hassett Divided Taxes ad Firm Valuatio: New Evidece. America Ecoomic Review 96 (2): Auerbach, Ala J Taxatio ad Corporate Fiacial Policy. Hadbook of Public Ecoomics 3: Auerbach, Ala J., ad Kevi A. Hassett The 2003 Divided Tax Cuts ad the Value of the Firm: A Evet Study. I Taxig Corporate Icome i the 21st Cetury, edited by Ala J Auerbach, James R. Hies, ad Joel B. Slemrod, Bloui, Jeifer L., Jaa S. Raedy, ad Douglas A. Shackelford Divideds, Share Repurchases, ad Tax Clieteles: Evidece from the 2003 Reductios i Shareholder Taxes. The Accoutig Review 86 (3): Brow, Jeffrey R., Nellie Liag, ad Scott Weisbeer Executive Fiacial Icetives ad Payout Policy: Firm Resposes to the 2003 Divided Tax Cut. The Joural of Fiace 62 (4): Chetty, Raj, ad Emmauel Saez Divided Taxes ad Corporate Behavior: Evidece from the 2003 Divided Tax Cut. Quarterly Joural of Ecoomics 120 (3): Divided ad Corporate Taxatio i a Agecy Model of the Firm. America Ecoomic Joural: Ecoomic Policy 2 (3): Departmet of the Treasury Report of the Departmet of the Treasury o Itegratio of the Idividual ad Corporate Tax Systems. Washigto DC: Departmet of the Treasury.