The Dividend Clientele Hypothesis : Evidence from the 2003 Tax Act ∗

In this paper, I test the dividend clientele hypothesis (DCH) by examining the impact of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the 2003 tax act) on household portfolio dividend yields. The DCH predicts that the 2003 tax act, which reduced the tax-disadvantage of dividends differentially across the income distribution, would cause high income households to shift their portfolios towards dividend paying stocks relatively more than lower income households. Using the 2001 and 2004 Surveys of Consumer Finances (SCF), I examine how changes in tax rates affect changes in household portfolio dividend yields. I find that the 2003 tax act caused households in the highest (35%) tax bracket to increase their portfolio dividend yields by 1.1 percentage points more than those in the next (33%) tax bracket, and by 2.6 percentage points more than those two tax brackets (28%) below. Compared to a 2.1 percent average dividend yield in 2001, these responses are large and economically significant. Using the 2007 SCF, I find that the reduced variation in dividend tax rates across households caused portfolio dividend yields to become homogeneous within three years of the tax act. Using a battery of sensitivity checks, I verify that these findings are not driven by other explanations for changes in dividend preferences, such as changes in optimism or risk-aversion. ∗I am grateful to my dissertation committee members, Amy Dittmar, Matthew Shapiro, Joel Slemrod and Jeff Smith for invaluable guidance, to Kevin Moore for assistance with using the Survey of Consumer Finances data, and to Daniel Feenberg for assistance with the NBER TAXSIM model. Charlie Brown, Jim Hines, Sara LaLumia, Sebastien Bradley, Josh Cherry, Osborne Jackson, Ryan Nunn, Todd Pugatch, participants at the UM public finance and labor seminars and participants at the 2007 Midwest Economics Association Annual Meetings provided useful feedback. †Ph.D. Candidate, Department of Economics, University of Michigan: [email protected] The Dividend Clientele Hypothesis Laura Kawano