Firm Heterogeneity and the Long-Run E ects of Dividend Tax Reform

Firm Heterogeneity and the Long-Run E ects of Dividend Tax Reform F. Gourio and J. Miao Presented by Román Fossati Universidad Carlos III November 2009 Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 1 / 25

Introduction Question What are the LR e ects of dividend taxation on aggregate capital accumulation and productivity? Motivation and Related Literature In 2003 the USA Congress cut the dividend and capital gains tax rates and it could be made permanent from now on. Economists disagree on the economic e ects of dividend taxation on investment. Two views are prevalent: Traditional view: the marginal source of funds is new equity)a dividend tax cut reduces the user cost of capital)raises investment (Poterba and Summers 1983 and 1985 using UK data). New View: rms use internal funds to nance investment)dividend taxation does not in uence the user cost of capital and investment.(desai and Goolsbee 2004 using US data). Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 2 / 25

Introduction Auerbach and Hassett (2002) show that in US rms behave according to both views, an indication of substantial heterogeneity in the data. The insight Firm heterogeneity plays a key role: depending on its productivity and its capital stock, a rm reacts according to these di erent views. The idea to answer this question: They build a DGE model in which there is a continuum of rms subject to idiosyncratic productivity shocks. The results They nd that a D tax cut raises aggregate productivity by reducing the frictions in the reallocation of capital across rms When both D and K gains tax rates are cut from 25 and 20 %, respectively, to 15% permanently, the aggregate LR K stock increases by about 4%. Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 3 / 25

Introduction They take into account three nance regimes: Equity issuance regime: the marginal source of nance is new equity (which re ects the traditional view) Liquidity constrained regime: rm s investment is limited to the amount of retained earnings Dividend distribution regime: the marginal source of nance is retained earnings (re ects the new view) Because of rm heterogeneity, at any point in time di erent rms may be in di erent nance regimes)respond to the dividend tax cut in di erent ways Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 4 / 25

Introduction Taking data from the COMPUTSTAT database we can see the averages across years from 1988 to 2002 (before the tax cut): Firms issuing equity are more productive (earnings-to-capital ratio), small (capital) and have high Tobin s q these growth rms (highest I/K) have good investment opportunities, and require external nance to make investments. The two other groups have similar investments, but the rms paying dividends have higher Tobin s q and higher productivity. Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 5 / 25

Introduction After the 2003 dividend tax cut: Agg. dividends increased signi cantly (ratio of D/GDP increased from 3.8% to 5.3% -avg. 1988-2002 vs 2003-2006-). Equity issuance, aggregate investment, and aggregate earnings also rose signi cantly. the share of rms in the LCR fell and the shares of rms in the EIR and DDR rose. they present a model that produces this e ect where the change in the rm distribution across nance regimes is an important mechanism. Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 6 / 25

Model Economic Environment t = 0, 1,..., in nite horizon, discrete time there is a continuum of rms facing idiosyncratic shocks and adjustment costs which: accumulates K, and make nancing decisions a representative household a government nance lump-sum transfers with taxes on corporate income, τ c dividends, τ d labor and interest income, τ i capital gains, τ g Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 7 / 25

Model: Economic environment The required return to equity (RRE) is R t = 1 P t E t [(1 τ d )d t+1 + (1 τ g )(P t+1 s t+1 )] (1) where P t+1 =ex-dividend value of equity, and s t+1 =value of issued new shares The steady state RRE in equilibrium satis es: De ne the cum-dividend equity value as from eqs. (1) to (3) we have: R t = (1 τ i )r (2) V t = P t s t + (1 τ d ) (1 τ g ) d t+1 (3) V t = (1 τ d ) (1 τ g ) d E t [V t+1 ] t s t + 1 + r(1 τ i )/(1 τ g ) they use this equation to formulate the rm s DPP Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 8 / 25 (4)

Model: Economic Environment Firms The rm chooses investment and nancial policies to max equity value: 1 τ V (k, z; w) = d max d s (5) k 0,x,s,d 1 τ g Z 1 + V (k 0 1 + r(1 τ i )/(1 τ g ) t+1, z 0 ; w)q(z, dz 0 ) s.t.: x + ψx 2 2k + d = (1 τ c )π(k, z; w) + τ c δk + s k 0 = (1 δ)k + x d 0 s 0 The solutions are the policy functions: x = x(k, z, w), k 0 = g(k, z, w), s = s(k, z, w), d = d(k, z, w). There is a cross sectional distribution of rms over the states µ(z, k). Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 9 / 25

Model: Economic Environment Households Representative household static optimization problem: s.t. Z C = (1 τ d ) Government +(1 τ i )wl + T max β t u(c t, L t ) t1 Z d(k, z; w)µ(dk, dz) (1 τ g ) s(k, z; w)µ(dk, dz) It collects corporate income taxes, dividend taxes, personal income taxes, and capital gains taxes, and transfers these tax revenues to the HH Z Z T = τ c [π(k, z; w) δk]µ(dk, dz) + τ d d(k, z; w)µ(dk, dz) Z τ g s(k, z; w)µ(dk, dz) + τ i wl Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 10 / 25

Model: Stationary Equilibrium A stationary equilibrium consists of a constant wage rate w; a stationary distribution of rms µ ; aggregate quantities, C (z, k, w), I (z, k, w), Ψ(z, k, w), Y (z, k, w), L d (z, k, w), L s (z, k, w); and decision rules, k 0 = g(k; z; w); x = x(k; z; w); s = s(k; z; w); d = d(k; z; w) ; such that i) the decision rules solve the rm s problem ii) C () and L s () solve the HH problem iii) µ is the stationary distribution of rms, iv) T satis es the government budget constraint, and v) markets clear: L d (µ, w) = L s (µ, w) C (µ, w) + I (µ, w) + Ψ(µ, w) = Y (µ, w) Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 11 / 25

Analysis of A Single Firm s Decision Problem (Partial Eqlm) Rewrite the DPP as a sequence problem s.t.: max E x t,k t+1,s t " t=0 # 1 1 τ d d t s t 1 + r(1 τ i )/(1 τ g ) 1 τ g (6) x t + ψx t 2 + d t 2k t = (1 τ c )π(k t, z t ; w) + τ c δk t + s t (7) k t+1 = (1 δ)k t + x t (8) d t 0 (9) s t 0 (10) Let q t, λ d t and λ s t be the Lagrange multipliers associated with the last 3 constraints q t =shadow price of capital (marginal q) Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 12 / 25

Analysis of A Single Firm s Decision Problem FOCs k t+1 : q t = s t : 1 τ d + λ d t + λ s t = 1 1 τ g 1 τd x t : q t = + λ d t 1 + ψx t 1 τ g k t 1 1 + r(1 τ i )/(1 τ g ) E t fq t+1 (1 δ)+ " 1 τd d t + λ d t+1 (1 τ c )π(k t, z t ; w) + τ c δk t + ψ 1 τ g 2 xt+1 k t+1 2 #) Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 13 / 25

Analysis of A Single Firm s Decision Problem In particular, the FOC w.r.t. s t determines the nancial policy of the rm: s t : 1 τ d + λ d t + λ s t = 1 (11) 1 τ g Interpretation: LHS= Bene ts: Raising 1 unit of new E to pay dividends relaxes the dividend constraint, the share repurchase constraint, and the shareholder receives 1 τ d 1 τ g units of after-tax dividends. RHS= marginal cost to the shareholder: 1 unit increase in new share lowers E value by 1 unit Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 14 / 25

Analysis of A Single Firm s Decision Problem s t : 1 τ d + λ d t + λ s t = 1 1 τ g If τ d = τ g there is no tax di erential between dividends and retained earnings. Eq. (12) implies that λ d t = λ s t = 0 ) rm s nancial policy is irrelevant (MM irrelevance theorem): it does not matter for rm value to retain earnings for use as internal nance, or to distribute D and issue E in the external equity market More formally, in the d t indeterminate s t can be determined, but d t and s t are Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 15 / 25

Analysis of A Single Firm s Decision Problem If τ d 6= τ g ) rm 0 s nancial policy matters. Before the 2003 τ d > τ g )we cannot have λ d t = λ s t = 0 )it is not optimal for the rm to simult. issue new E and distribute D (the nancial dec. change E value) Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 16 / 25

Analysis of A Single Firm s Decision Problem If τ d 6= τ g ) rm 0 s nancial policy matters. Before the 2003 τ d > τ g )we cannot have λ d t = λ s t = 0 )it is not optimal for the rm to simult. issue new E and distribute D (the nancial dec. change E value) This implies that one of the constraints d t 0 or s t 0 must be binding)3 cases to consider: d t > 0, s t = 0 : Distribution Regime: the rm has enough retained earnings to nance I and to distribute D d t = 0, s t > 0 : Equity Issuance Regime: the rm does not have enough internal funds to distribute D. The marginal source of I nance is the external equity market d t = 0, s t = 0 : Liquidity Constrained Regime: the rm exhausts all internal funds to nance investment and neither distribute D nor issue E (because the marginal return to investment does not justify the reduction in E value -due to share dilution-). In this last regime, a windfall addition to current earnings, will raise I. Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 19 / 25

Analysis of A Single Firm s Decision Problem A rm will change regime according to shocks and K accumulation. In the cross section with rm heterogeneity, di erent rms may lie in di erent nance regimes. Quantitative Results The model has no closed-form solution for the stationary equilibrium)they numerically compute the approximate equilibrium. They calibrate the model to match some moments from the COMPUSTAT database. Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 20 / 25

Quantitative Results: General Equilibrium Quantitatively the model matches well the facts presented before First policy experiment: taxes rates cut from τ d =.25, τ g =.20 to τ d =.22, τ g =.20 : Fewer rms are constrained: some rms in the LCR move to the EIR and some other to the DDR The rms in the EIR account for most of the increase in I These behavior is consistent with the traditional view of dividend taxation and with the empirical results (what really happened) Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 21 / 25

Quantitative Results: General Equilibrium Percentage changes from the initial steady state the long-run aggregate K, output, consumption, and w increase the wage increases: more rms are in the EIR and these rms are pro table and invest more) " L d # L s because the HH receives higher payouts (are wealthier) (GE feedback) Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 22 / 25

Quantitative Results: General Equilibrium Second policy experiment: taxes rates cut from τ d =.25, τ g =.20 to τ d =.15, τ g =.15 : rms do not face the tax di erential cost of external E nance)mm dividend policy irrelevance theorem holds) D and new E values are indeterminate the increases in agg. K, Y, C and w are higher: in particular, agg. K "= 4.26% Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 23 / 25

Quantitative Results: General Equilibrium Productivity: we consider the changes of τ d from 0.25 to 0.22 and 0.20 TFP and Labor productivity increases after the tax reduction: some liquidity constrained rms move to the EIR and they attract more K and Labor)the allocation of K and L is more e cient Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 24 / 25

Final Remarks This article presents DGEM to analyze the LR e ects of the dividend tax reform on agg. K accumulation. Two features are central to the analysis: Firm heterogeneity in productivity and GE. Firm heterogeneity implies that rms may lie in di erent nance regimes over time and respond to dividend taxation in di erent ways In particular, some rms behave according to the traditional view of dividend taxation and others behave according to the new view GE provides better estimates The results indicate that: When both D and K gains tax rates are cut from 25 and 20 %, respectively, to the same 15 % permanently, the agg. LR capital stock increases by about 4 %. Fossati Román (Universidad Carlos III) Firm Heterogeneity and the Long-Run E ects of Dividend Tax November Reform 2009 25 / 25