Howdy,
I have some questions about the dividend tax cut
(elimination). Let's suppose that the elimination of
taxes on dividend income to stock holders is
instituded and it is a complete suprise to the public,
so that no adjustment can take place either in
expectation of it being passed, or after it is passed
but before it takes effect. Let's also assume that
growth opportunities are not an issue, so the price is
wholly dependent on dividends.
If the price of a stock is the PV of the dividend
stream into the future, then should there merely be a
one time jump in the value of a stock as a result?
More concretely, if the tax rate was T, then a
dividend was worth (1-T)D, where D is the amount of
the dividend. And the present value of the
perpetuity, i.e. the dividend stream, would be
(1-T)D/r, where r is the interest rate (right?). So
the price of the of the stock would be P=(1-T)D/r.
Now the suprise tax cut comes into effect. The price
of the stock should jump to P'=(1-0)D/r=D/r. Thus,
there should be merely a one off jump in the share
price by the amount P'-P=[D/r]-[(1-T)D/r]=(D+T)/r.
Is this correct? Should the tax rate on dividend
income be included in the pricing of the shares, and
should we see a jump in prices? I suppose that
intstead of T:=tax rate on dividends, I could have
used T:=Td-To, where Td is the tax rate on dividends
and To is the tax rate on some "other" investment.
Would that be correct?
Okay. Assuming the above is correct, then the rate of
return on a stock should increase from (1-T)D/P to
D/P'. The increase in the rate of return then is
=[(1-T)D/P]-[D/P']
=[D/(D/r)]-[(1-T)D/{(1-T)D/r}]
=r-r
=0.
So the increase in the rate of return on stocks should
be equal to zero. Stocks are no more profitable after
the tax cut than before--it shouldn't help the market
at all.
If dividend income tax is not priced into the stock,
then again, there should be no change in the
profitability of stocks, because P=P' and 1-0=1.
The same should be true if T:=Td-To, correct?
Is my conclusion that the dividend tax cut should have
no impact on the rate of return of stocks correct? Is
the only effect of such a tax cut to provide a once
off permanent increase in the wealth of stock holders
as the price jumps from P to P', thus stimulating the
economy solely through the wealth effect of that
change?
If this conclusion is correct, how will loosening the
two assumptions, first that the cut is publicly known
before it takes effect and second that the present
value of growth opportunities are taken into account
in share pricing, affect the conclusion? Will
loosening the second assumption change corporate
behavior viz. investing in growth vs. paying
dividends? What should we expect that change to be?
Has this question already been asked on this list and
I missed it?
Curiously yours,
jsh
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