CAPITAL INVESTMENT EFFECTS OF DIVIDEND IMPUTATION, CAPITAL GAINS TAX AND THE INVESTMENT TAX CREDIT
by
Ervin L. Black*
Assistant Professor
Joseph Legoria**
Assistant Professor
Keith F. Sellers*
Associate Professor
*Department of Accounting
College of Business
University of Arkansas
Fayetteville, AR 72701
(501) 575-6803
email:
email:
**School of Accountancy
College of Business and Industry
Mississippi State University
Mississippi State, MS 39762-5661
(601) 325-1634
email:
This paper has benefited from comments of Terry Shevlin, David Burgstahler and other workshop participants at the University of Washington and participants at the Tenth Asian-Pacific Conference on International Accounting Issues.
CAPITAL INVESTMENT EFFECTS OF DIVIDEND IMPUTATION, CAPITAL GAINS TAX AND THE INVESTMENT TAX CREDIT
Abstract
We examine the effects of specific tax reforms on corporate capital investment in New Zealand, Australia, and Canada. The empirical findings indicate that: (1) tax reform in each of the three countries stimulated corporate capital investment, (2) tax reform altered how dividend payout ratios impacted capital investment in Canada but not in the other two countries, and (3) tax reform altered how capital intensity influenced investment in New Zealand and Australia but not Canada. Additional analyses are performed by dividing the samples into portfolios based on historical dividend payout policies and capital intensity. The findings indicate that tax reform impacted corporate investment differently depending on a firm’s dividend payout and capital intensity. In summary, we demonstrate the impact of specific tax reforms in three countries on corporate investment. Our findings suggest that policy makers can make more informed decisions regarding tax policy as it affects capital investment by examining the impact of tax reforms in other countries.
CAPITAL INVESTMENT EFFECTS OF DIVIDEND IMPUTATION, CAPITAL GAINS TAX AND THE INVESTMENT TAX CREDIT
INTRODUCTION
Economic theory has long held that the level of business investment in fixed assets is a critical determinant of business output and empirical research has clearly demonstrated this relation.[1] Based on this association, the stimulation of capital investment has been one of the principal objectives of tax policy in the U.S. for decades. Historically, Congress has attempted to stimulate capital investment through direct incentives such as the investment tax credit (ITC) or generous accelerated depreciation allowances. Surprisingly, research has shown that these incentives produce relatively small or no incremental increase in capital investment.
Macroeconomic theory asserts that tax policy should encourage investment in capital assets if the tax system lowers the marginal cost of investment. This theory has been the foundation of most investment incentives such as the ITC. For example, by directly lowering the cost of a fixed asset, the ITC should result in more investment in fixed assets. One weakness with such a targeted incentive is that all qualifying investment generates a credit, not just incremental investments. Furthermore, it is clear that at least some targeted tax incentives have led to suboptimal investment decisions. An alternative method of lowering the cost of capital and thus stimulating investment for businesses is to simply lower the overall tax burden on business profits.
The purpose of this study is to determine the effects of specific income tax reforms on corporate fixed investment. Specifically, we examine the incremental effects of dividend imputation, capital gains taxes, and investment tax credits on investment. Evidence that these specific tax reforms result in increased or decreased investment is relevant for future tax policy debates in the U.S. and elsewhere. Ongoing debates over the merits of alternative tax reforms, such as capital gains tax preferences and dividend imputation, indicate that this is a timely and relevant research topic.
In order to determine the relative and incremental effects of various tax rates and incentives, tax policy changes in three countries are examined. In 1987, New Zealand adopted dividend imputation and significantly lowered corporate tax rates. Dividend imputation has the effect of eliminating the double tax on corporate profits. The second country examined in the study is Australia. In 1987, Australia adopted a tax reform plan similar to New Zealand’s. However, Australia also instituted for the first time a capital gains tax on sales of corporate stocks. This has the effect of lowering the combined tax on corporate profits which were distributed, but raising the combined rates on undistributed profit.
The third country to be examined is Canada. In 1972, Canada adopted a tax reform package similar to the one described above for Australia. Specifically, Canada addressed the double tax on dividends through a dividendimputation plan while instituting a first time tax on capital gains. However, Canada also simultaneously adopted an ITC. It is important to note that all three countries were attempting to stimulate investment through their respective tax reforms.[2] While all three countries adopted similar forms of dividend imputation in an attempt to eliminate the double taxation of distributed corporate profits they differed in their
approaches on taxing capital gains and for providing direct investment incentives.
This combination of similar and different tax changes among the three countries offers an ideal setting for our study. By treating the tax changes of these countries as experiments in tax and investment policy, we can compare the relative and incremental effects of capital gain taxes and investment tax credits in conjunction with the adoption of dividend imputation. Economic conditions differed over time and among countries and general economic conditions certainly impact investment in fixed assets. However, we control for various nontax variables that affect corporate investment in property, plant and equipment.
Our empirical findings indicate that: (1) tax reform in each of the three countries stimulated corporate investment, (2) tax reform altered how dividend payout ratios impacted investment in Canada but not in the other two countries, and (3) tax reform altered how capital intensity influenced investment in New Zealand and Australia but not Canada. In summary, we find evidence that specific tax reforms introduced in each of the three countries impacted corporate investment. Thus, our findings suggest that policy makers can make more informed decisions regarding tax policy as it affects capital investment by examining the impact of tax reforms in other countries.
In the following sections we examine prior research, develop hypotheses, discuss research design, provide results, and present conclusions and implications from our findings.
PRIOR RESEARCH ON TAXES AND INVESTMENT
Prior research on investment and taxes has generally relied on either the "user cost of capital" approach developed by Jorgensen (1963) and Hall and Jorgensen (1967) or Tobin's (1969) qtheory. However, researchers have had only limited success in linking tax changes to changes in investment using these models.[3] In fact, simple time series models or ad hoc models using variables such as output, cash flow, profits, and sales tend to predict total investment better than tax changes or their anticipated effects to cost of capital.[4]
Recently, studies utilizing firm specific panel data and/or specific tax reforms have been more successful in demonstrating a shift in corporate investment in response to tax changes. For example, Rosacher et al. (1993) examined how effective the ITC was over the period from its original enactment in 1962 to its repeal in 1986. The authors divide their sample into a test group consisting of firms qualifying for the ITC and a control group consisting of firms that do not qualify for the ITC. Using a univariate BoxJenkins interrupted analysis, they find that ITC enactments and rate enhancements have a positive effect on investment whereas repeals have a negative effect on investment. Ayres (1987) employed financial capital markets research methodology in testing the effects of the ITC on security returns. She finds a significant association between abnormal security prices and the amount of ITC received (lost) do to changes in the ITC. Her results indicate that changes in the ITC result in a reallocation of capital among firms.
Moore et al. (1987) test whether tax advantages offered by various states in the U.S. are important in the decision of foreign corporations to invest in one state rather than another. Their findings indicate that tax structures relying on the unitary method of accounting
significantly impact the amounts of investment while corporate tax rates do not.[5] However, in a subsequent article Swenson (1989) used an experimental economics approach to test whether taxation impacted investment. He found that progressive tax regimes tend to decrease demand for fixed assets while tax credits resulted in increased demand for those assets. In addition, Vines et al. (1994) found that states with strong business interests (e.g. large number of firms and high average business income per firm) tend to have lower state corporate tax rates. Cassou (1997) studied the impact of tax policy on the flow of foreign investment between the U.S and other countries. His findings indicate there is a significant negative relation between U.S corporate tax rates and the level of foreign direct investment. These findings are consistent with Moore et al. (1987) and provide further evidence that tax policy is an important consideration for foreign firms when deciding where to invest.
Kern (1994) tested the impact of the Economic Recovery Act of 1981 (ERTA) on corporate investment. Under the ERTA, longlived assets received greater benefits than shortlived assets. Kern divided her sample into three portfolios based on the after-tax benefits received from ERTA. The findings of her study indicate that firms receiving the greatest tax benefits exhibited the largest change in investment patterns and suggest that tax policy can have an effect on investment. However, Courtenay et al. (1989) found evidence that the ERTA disturbed the degree of neutrality in the tax law existing between capital intensive and noncapital intensive firms. More specifically, they found that only capital intensive firms
demonstrated significantly positive abnormal returns during their test period surrounding the passage of ERTA. They concluded that all ERTA may have accomplished was a reallocation of resources from noncapital intensive firms to capital intensive firms. In addition, Swenson (1987) determined that the Accelerated Cost Recovery System (ACRS) passed under ERTA was non-neutral during periods of high inflation.[6]
In 1984, the United Kingdom passed tax reform legislation which reduced corporate tax rates and lengthened the asset lives for many depreciable assets. Moon and Hodges (1989) examined how the 1984 U.K. tax reform affected the aftertax cost of capital facing firms. Their analysis indicates that the 1984 U.K. tax reform resulted in many investments in plant and equipment becoming less attractive than they were before. Morgan (1992) surveyed the largest U.K. firms to determine how sensitive these firms were to the 1984 U.K. tax reform. He found that most of the firms sensitive to the 1984 tax changes (e.g. firms with high marginal tax rates) would have scaled back their investment rather than have increased it.
In an examination of the Tax Reform Act (TRA) of 1986, Cummins and Hassett (1992) find a significant relation between the cost of capital and the level of investment in equipment and structures. Auerbach et al. (1991) find that the TRA of 1986 resulted in less investment than what was predicted based on investment behavior from 1953 to 1985. Cummins et al. (1994) found that after every tax reform enacted in the United States since 1962, the level of investment changed. In a subsequent article, Cummins et al. (1996) examine various tax
reforms in 14 countries and find evidence that taxes, in general, can be linked to changes in investment.
Finally, Kinney and Trezevant (1993) analyzed whether taxes impact the timing of capital expenditures. More specifically, they argue that the present value of investmentrelated tax shields is greater if a depreciable asset is purchased and placed in service in the current year compared to the subsequent year. As a result, they predict greater capital expenditures are made in the fourth quarter of the current year, as opposed to the first of quarter of the following year. They find support for this prediction as their results indicate firms make greater capital expenditures in the fourth quarter of current year rather than first quarter of the next year.
In summary, prior research has determined that the long suspected link between taxes and investment does exist. Unfortunately, no previous research has successfully demonstrated the investment effects of specific tax reforms such as reduction of corporate tax rates or elimination of the double tax on dividends. Thus, while tax policymakers know that their decisions might impact the level of investment, they do not have information as to which specific tax changes result in changes in actual investment behavior.
The objective of our research study is to increase understanding of the impact of specific tax changes; i.e., changes in the structure of the tax system on distributed and nondistributed corporate earnings and their effect on corporate investment behavior. By examining the investment effects in countries that have implemented specific tax reforms, we derive implications of the potential effects of similar changes in the U.S. and other countries.[7]
HYPOTHESIS DEVELOPMENT
Taxes, the Cost of Capital, and Capital Investment
The purpose of this section is to demonstrate the various linkages between components of a capital investment model and the various tax changes examined in this study. Firms should accept additional investment opportunities if the net present value of the marginal investment is positive. Assuming the firm has sufficient capital resources, it would invest if:
(1)
where:CFt = the net cash flows during period t, and
k = the investor’s required rate of return
Therefore, taxes and tax changes impact the investment decision to the extent that they impact the timing of projected net cash flows (t), the amount of projected net cash flows (CF), discount rates (k), or a combination of these factors. Corporate level taxes clearly affect the timing and amount of cash flows. Shareholder level taxes affect corporate investment decisions less directly, through their impact on the corporate cost of capital. In the absence of shareholder level taxes, the corporate cost of equity is equal to the expected rate of return to shareholders in the form of dividends and appreciation. When shareholder level taxes are imposed, the corporate cost of equity capital and total shareholder return differ by the amount of total shareholder level taxes. Assuming that a corporation’s risk adjusted required rate of return on marginal investments is equal to the corporate cost of capital, the relationship between individual shareholder taxes and the cost of capital under a classical double tax system can be represented as:
(2)
where:
Ce = corporate cost of equity,
Ts = total shareholder level taxes,
Rs = total expected after-tax return to shareholders,
Rd = expected shareholder return in the form of dividends,
Td = marginal tax rates on dividend income, and
Rcg = expected shareholder return in the form of share appreciation (capital gain)
The corporation’s cost of equity capital differs from the shareholders’ after-tax return by the amount of the shareholder-level tax, in this case equal to Rd*Td.[8] Prior to the tax reforms examined in this study, neither Australia, Canada nor New Zealand imposed a tax on realized capital gains. Thus, Rcg is equal to a shareholder’s pre and post-tax return in the form of share appreciation. It should be noted that, in most instances where statutory rates for Td are non-zero, its marginal value is non-observable. Various tax clienteles will naturally concentrate their investments in appropriate stocks based on their tax position and the expected amount and form of the return. This clientele effect, combined with variations in the timing of dividend distributions, make the present value of the tax impossible to estimate.
New Zealand
Dividend imputation modifies the tax on dividends by attaching a credit, equal to the taxes already paid by the corporation on behalf of the dividend, to dividend distributions. As outlined in the appendix, if individual tax rates exceed corporate tax rates, the imputation credit will only partially offset the individual level taxes. While some view this as only partially reducing the classic double tax, the resulting cumulative tax burden on distributed corporate earnings is equal to only the higher individual tax rate. In the case where the corporate tax rate exceeds the tax rate of the recipient shareholder and the imputation credit can be fully utilized, the resulting cumulative tax burden is once again equal to the individual shareholder’s marginal tax rate. However, the after-tax dividend return, as viewed by the shareholder, is actually higher than the pre-tax return. These conclusions are evident in the following when we add the tax benefit of the imputation credit:
Rs = Rd – (Rdg * Td) + (Rdg * Tc) + Rcg(3)
where:
Rdg = the dividend return paid to shareholders, “grossed-up” by the amount of
corporate level tax paid on account of the dividend, and
Tc = the corporate tax rate paid on the grossed-up distributed earnings.
Equation (3) captures the cost of capital in New Zealand after the tax reform and accurately reflects the effects of the imputation credit when the shareholder has a positive tax rate and sufficient income. If the recipient has insufficient income, some or all of the imputation credit will be lost. Subtracting equation (2), which measures the after-tax return to shareholders prior to dividend imputation from equation (3), the after-tax return after the tax reform, reveals that shareholders’ after-tax return in New Zealand changed by an amount equal to (Rdg * Tc) - (Rdg * Tc * Td). When shareholder tax rates (Td) fall between zero and 100 percent, this will result in a positive change in shareholder’s after-tax returns. Thus, the tax reform in New Zealand clearly enhanced shareholder after-tax returns for non-tax exempt shareholders.