Taxes, Volatility and the Cost of Equity Capital: An Analysis of the Jobs & Growth Tax Relief Reconciliation Act of 2003

Abstract:     
We hypothesize that the 2003 decrease in individual tax rates on dividends and capital gains should have been followed by a decline in the cost of capital and increased volatility, especially for dividend paying firms. We observe a significantly positive increase in the volatility of daily returns which is larger for dividend than non-dividend-paying firms, and is positively associated with dividend yield. We find that the increase in volatility dampened the cost of capital reduction brought about by the tax reduction. We also analyze changes in ERCs as a proxy for changes in firm cost of capital. The heightened investor response to unexpected earnings information is larger for dividend-paying firms overall, but is not positively associated with dividend yield. These results suggest that as dividend yields increase, the initial effect of the tax rate changes on cost of capital is offset by increased return volatility from those same rate changes.

Number of Pages in PDF File: 35

working papers series