Did the 2003 Tax Act Increase Capital Investments by Corporations?

Abstract

This study investigates the role of shareholder-level taxes on corporate investment. We use the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (hereafter, 2003 Tax Act) as a quasi-natural experiment to answer our research questions. The 2003 Tax Act reduced shareholder-level taxes on dividends and capital gains. Relative to legislative changes in 1993 and 1997 that also impacted shareholder-level taxes, the 2003 Tax Act changed tax rates on both capital gains and dividends and led to a dramatic decrease in the average marginal shareholder-level tax rate. Furthermore, prior research suggests that the 2003 Tax Act increased firms' share prices (Auerbach and Hassett 2006) and reduced firms' cost of equity capital (Dhaliwal et al. 2007). We predict that firms increased investment in response to the Act.Our study focuses on corporate investment for two reasons. First, a stated goal of the 2003 Tax Act was to encourage capital investment by corporations. Second, capital investment is a fundamental component of firm value (Hanlon and Heitzman 2010). Thus, our study is of interest to policymakers and academics. Whether changes in shareholder-level taxes will impact corporate investment is an open empirical question. Prior research suggests that firms could increase dividends in response to reductions in shareholder-level taxes instead of increasing investment (Chetty and Saez 2005). In addition, some firms may fund investment with internal funds and not equity, in which case, any reduction in the cost of equity capital derived from the 2003 Tax Act is unlikely to impact investment.We regress capital expenditures on an indicator variable equal to one for time periods after the Act, and controls for cross-sectional differences in capital expenditures. We first document that capital expenditures increase after the 2003 Tax Act. Because the economy was coming out of a recession around the 2003 Tax Act, it is possible that macroeconomic conditions unrelated to taxes caused investment to increase. To better link our findings to the 2003 Tax Act, we use a difference-in-differences research design to show that this increase in capital expenditures varies predictably with two shareholder-level tax-motivated hypotheses. First, we find that the increase in investment is smaller for firms largely held by investors that are less sensitive to shareholder-level taxes. Second, we find that the increase in investment is larger for firms most likely to fund investment from new equity issuances, rather than internal funds.In additional analysis, we examine how firms' dividend payout policy impacts our results. We find that while the majority of firms increase investment after the tax cut, a small subset of larger, older, and cash-rich firms increased dividend payout instead. Overall, our results suggest that, consistent with the intent of policymakers, the shareholder-level tax rate reductions set forth in the 2003 Tax Act increased corporate investment. Our findings add further evidence to the question of whether taxes impact firms' value and investment.