How do corporate payout policies affect the impact of tax cuts?

President-elect Donald Trump has promised tax cuts in the United States. Research indicates that corporate payout policy (dividends and share buybacks) shapes firms’ financial decision-making and, in turn, the wider economy. But there are trade-offs as changes affect public spending and debt levels.

Profitable firms can distribute their earnings to shareholders – typically through dividend payments and share buybacks – or retain them for reinvestment in the business. These choices are referred to as a firm’s corporate payout policy.

A share buyback or repurchase is the reacquisition by a firm of its shares. This represents an alternative to dividend payments as it implies an increase in the price of pre-existing shares.

Corporate payout policy broadly reflects a firm’s financial health, growth prospects and management strategy. Factors influencing payout policy decisions include the company’s profitability, cash flow stability, investment opportunities, tax considerations and broader market conditions.

In the United States, the distribution of dividends was the main corporate payout policy employed in the early 20^th century. But in recent decades, this has shifted to a mix of dividends and share buybacks.

Share buybacks have become increasingly popular due to favourable tax treatment and a focus on share price management. Today, companies use both methods, with buybacks frequently taking the lead.

Indeed, the share of firms engaging in payout policy and share buybacks on their own has increased since 1990, at the expense of firms with no payout policy and those using dividends only (see Figure 1, panel A).

If firms that do not engage in either type of payout policy are excluded, this trend is even starker (see Figure 1, panel B). By 2022, roughly 50% of these firms preferred to use share buybacks, 10% to pay dividends and the remaining 40% both payout methods.

Figure 1: Firm payout policy, 1990-2022

Source: Compustat
Note: To calculate the firm shares, we use publicly listed firms at the major US stock exchanges: NYSE, AMEX and NASDAQ, excluding financial firms and utilities (Standard Industrial Classification (SIC) codes 6000-6999 and 4900-4999, respectively) because of their statutory capital requirements and other regulatory restrictions. We exclude observations with negative data for total assets, dividends and share repurchases. Our final sample for calculating the firm shares includes an unbalanced panel of 170,581 firm-year observations.

Tax reforms and payout policy

Given that tax reforms affect a firm’s profitability and hence its investment and payout strategies, research has recently studied how firms’ different payout strategies might affect the intended consequences of changes to the tax structure (see, for example, Gourio and Miao, 2010 and 2011, which concentrate on dividend and capital gains taxes; and Chang et al, 2023, which considers corporate taxes).

Tax reform is generally motivated by the desire to stimulate firms’ investment directly by reductions in the corporate tax or to stimulate individuals’ spending directly through reductions in capital gains and dividend taxes.

These changes, in turn, are expected to lead to improved economic performance (aggregate output) and social welfare. Further, a point often glossed over by politicians is that these cuts need to be paid for by cutting government spending, increasing public borrowing, raising other taxes – such as tariffs on imports – or some combination of the three. Our analysis concentrates on the first two financing methods.

To explore these predictions further, we analyse the effect of introducing a separate market for pre-existing equity shares (this builds on existing studies, including Gourio and Miao, 2010 and 2011; Karabarbounis and Neiman, 2012 and 2014; Chen et al, 2017; and Chang et al, 2023).

This market allows for the simultaneous optimal choice of dividend repayments and share buybacks. This offers a less restrictive relationship between dividends and profits than in the studies cited above, which either assume different mixes of dividends and buybacks, or postulate that dividends are a constant fraction of firms’ profits.

Critically, firm-level data analysis provides empirical support for this extension (Asimakopoulos et al, 2024). In particular, it reveals that while dividends can be related to profits positively, they can also be negatively related depending on the shocks affecting the economy and the time horizon considered.

This research is motivated by the current policy plans emerging from the incoming US administration (see for example The Economist, policy brief, 2024) and past tax reforms in the United States, such as the Jobs and Growth Tax Relief Reconciliation Act in 2003 and Tax Cuts and Jobs Act of 2017).

It examines the impact of permanent 20% tax cuts in corporate income, capital gains and dividend income (this is in line with other studies in the area, such as Gourio and Miao, 2011; and Chang et al, 2023). In all cases, the tax cuts are financed by changes in non-distortionary government transfer payments and/or public debt, adjusted to satisfy the government’s budget constraint.

Additionally, to understand the quantitative implications of introducing a separate market for pre-existing equity shares, we can include the restricted case in which firms’ buybacks are not chosen optimally. This case assumes that dividends are a constant proportion of profits (Asimakopoulos et al, 2024).

Key findings

Based on a 20% permanent drop in respective tax rates, this research indicates that corporate tax cuts have the most potent effect on the economy, followed by capital gains cuts and then dividend tax cuts. For example, focusing only on the long run, GDP increases by about 1.2%, 0.7% and 0% for corporate, capital gains and dividend tax cuts, respectively.

But there are also trade-offs. First, tax cuts are not a free lunch since they must be financed via changes in public spending and debt, assuming no change in other taxes. In particular, the fiscal costs of corporate tax cuts are the highest, followed by dividend and capital gains cuts.

For example, the required changes in public spending and debt to finance these cuts include a fall in public spending of roughly 2% and a rise in public debt of 1.2% for the corporate tax. The comparable figures for capital gains tax are a 0.5% fall in public spending and a 0.7% rise in public debt, and for the dividend tax, a 0.8% fall in public spending and a 0% rise in public debt.

It is worth noting that these results pointing to the fiscal costs of cuts in corporate taxes are consistent with the empirical findings of other work (Chodorow-Reich et al, 2024). Similarly, the results for the ineffectiveness of the dividend tax cut are generally in line with previous empirical studies (Yagan, 2015 and Farre-Mensa et al, 2014).

A second trade-off involves allocating the GDP gains from tax cuts between consumption and investment. Corporate tax cuts score much better in terms of investment, capital, employment and GDP, but worse than cuts in capital gains taxes in terms of consumption.

On the other hand, a dividend tax reform generally has negligible effects on all of these aggregates since firms have to meet the increased appetite of their shareholders for dividends. This comes at the cost of funds used for investment.

Given that consumption is a significant driver of welfare, this trade-off explains why capital gains tax falls yield greater welfare than falls in corporate taxes. For example, when lifetime utility depends on consumption only, the gain in consumption in each period vis-à-vis the case before the tax cuts – the so-called compensating consumption supplement – is about 0.22% for the capital gains tax, 0.07% for the corporate tax and 0.03% for the dividend tax.

Finally, when we compare these findings with those of the other studies mentioned – by assuming that dividends are proportional to profits – we find that all tax reductions overstate the effects on the real economy and welfare relative to our analysis.

In particular, in the restricted model, GDP increases by about 1.9%, 1.1% and 0.36% for corporate, capital gains and dividend tax cuts, respectively. In addition, the compensating consumption supplement is about 0.3% for the capital gains tax, 0.6% for the corporate tax and 0.1% for the dividend tax.

Our interpretation is that this happens because the assumption that dividends are a constant fraction of profits in each period works like an automatic stabiliser, which releases funds for investment.

General lessons

Our analysis suggests that corporate payout policy plays a significant role in shaping firms’ financial decision-making and, in turn, the macroeconomy.

In particular, despite the significant beneficial aggregate effects of cuts in corporate and capital gains taxes, our research suggests that these gains are less than generally expected and cannot be self-financed.

Thus, given the latter, social and political value judgements relating to public spending/taxation and debt must be made when seeking to stimulate the economy via tax reform.