Did the 2003 Tax Act Reduce the Cost of Equity Capital?

Abstract

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the 2003 Tax Act) drastically reduced shareholder level taxes on equity income. If shareholder level taxation is an important component of cost of equity capital, then cost of equity should decrease after the 2003 Tax Act. Using the approach of Dhaliwal, Krull, Li, and Moser (2005) that relies on estimates of implied cost of equity capital, we find that cost of equity decreased by about 1.02% after the 2003 Tax Act. We also show that for firms largely held by institutional investors to whom the tax rate reduction does not apply, the decline in the cost of equity capital is smaller. These results suggest that the 2003 Tax Act may have achieved its intended goal of lowering the cost of equity capital. They also add further evidence to a more fundamental research question, that is, taxes impact valuation.

Keywords: Implied cost of capital, institutional ownership, dividend taxes, capital gain taxes

JEL Classification: G12, H24, M41