EFFECTS OF POTENTIAL TAX REFORMS 

ON STOCK MARKET YIELDS 

. 

Larry Dildine and Eric Toder 

U.8. Treasury Department 

OTA Paper 36 April 1979 

OTA papers are circulated so that the preliminary findings of tax 

research conducted by staff members and others associated with 

the Office of Tax Analysis may reach a wider audience. The views 

expressed are those of the authors, and do not reflect Treasury

policy. Comments are invited, but OTA papers should not be 

quoted without permission from the authors. Managing editors are 

Michael Kaufman and Gary Robbins. 

Office of Tax Analysis

U.S. Treasury Department, Room 1104 

Washington, D.C. 20220 

Issued: April 1979 
.. 

TABLG OF COUTENT8 ' 

INTRODUCTION e 0 e e 'e e 0' 0 1 

VIEWS OF FINANCIAL ANALYSTS ON TREASURY'S PRELIMINARY 

TAX REFORM PROPOSALS 0 e e 0 0 e 6 

TAX POLICY AND STOCK PRICES -- ANOTHER APPROACH TO 

ANALYSIS e e'. e e e e 0 0 e e e 0 e 15 

APPENDIX A. CALCULATION OF THE ANNUAL AFTER-TAX YIELD 

ON CORPORATE SHARES . . . . . . . . . . . . . . . 36 

APPENDIX B. HISTORICAL RELATIONSHIP OF PRICE APPRECIATION 

TOTAL RETURN FOR CORPORATE STOCKS . . . . . . . . . 43 

. 
LIST OF TABLES 

TABLE 1. EQUILIBPIUM RETURNS FOR DIFFERENT TAXPAYERS 18 

TABLE 2. DIVIDEND RELIEF/CAPITAL GAINS TRADEOFF 24 

TABLE 3. EFFECT OF PAYOUT RATIO ON DIVIDEND RELIEF/ 

CAPITAL GAINS TRADEOFF . . . . . 26 

TABLE 4. CORPORATE TAX CUT/CAPITAL GAINS TRADEOFF . . . 28 

. 
Effects of Potential Tax Reforms 

on Stock Market Yields 

Introduction 8nd Suramary 

t 

Tn 1977, #e Administration was developing a major tax 

reform program, including proposals to alter significantly 

cwrent methods of taxing corporate income. Among the 

specific proposals were full taxation of capital gains (as 

opposed to taxing 50 percent -- currently 40 percent -- of 

those gains), and reduction of double taxation of corporate 

income. When preliminary working papers prepared at the 

Treasury Department found their way into public circulation, 

some of the proposals raiped alarm in sections of the 

business community over possible negative effects on stock 

prices and investment. The proposal to tax capital gains at 

the same rate as ordinary income was singled out for special 

criticism. Some thought that the expectation of smaller 

after-tax returns from the sale of appreciated assets would 

discourage investment in corporate equity. . 

The authors are grateful to Harvey Galper and Michael 

Kaufman of the Office of Tax Analysis, to Craig Drill of 

First Boston Inc. and Marilyn V. Brown of Marilyn V. Brown, 

Inc. for their assistance in preparing this paper. 
-2-

The propooalr for full taxation of capital gains and 

relief of double taxation of corporate income in the 1977 

working papers were not included in the Administration's 1978 

tax 'reform recommendations and currently are not being 

considered by either the Adqinistration or Congress. 

However, structural reform of taxation of capital income 

remains a concept worthy of study. In this paper, we discuss 

how the proposals in the 1977 working papers would affect 

financial markets. In particular, we show that the long-run 

decline in share values from full taxation of capital gains 

could be offset by relatively small amounts of either tax 

relief on dividends or cuts in corporate tax rates. 

Currently, dividends received by corporate shareholders 

are taxed twice-first, through a corporate tax on income 

from which dividends are paid l(48 percent on corporate income 

I 

in excess of $50,000 in 19778 'currently 46 percent on 

corporate income in excess of $lOO,OOO), and then through 

inclusion of dividends received (with a $100 exemption) in 

shareholders' taxable income. i

i Two methods of relieving 

double taxation of corporate i come -- both termed partial 

integration because they applyi"to dividends, but not retainea 

earnings -- are the "dividend 1Jeduction" method and the 

"gross-up and credit" method. Under the dividend deduction 

method, corporations are allowtd to deduct dividends paid (as 
-3-

they currently deduct interest payments) naking the dividend 

taxable only to the shareholder. Under the wgross-up and 

credit" method, the relief is provided at the shareholder 

level by permitting the shareholder to take a tax credit for 

the portion of the corporate tax allocable to his dividend, 

while also including that tax in reported income. In effect, 

the "gross-up and credit" method converts the tax payment 

made by corporations on the portion of income paid out as 

dividends from an extra tax at the corporate level to a 

withholding tax on dividends creditable to shareholders in 

the same way taxes withheld against wages are creditable to 

employees. It can be shown that the dividend deduction and 

gross-up and credit methods are equivalent in the sense that 

they enable the corporation to provide the same increase in 

after-tax income to shareholders. 

The Treasury working papers proposed using the gross-up 

and credit method to provide partial relief from double 

taxation of corporate income. Partial relief was to be 

accomplished by providing the shareholder with a tax credit 

for a fraction of the tax paid at the coiporate level--i.e., 

for less than 46 percent of.gross dividends received. In our 

analysis, we found that, for a typical stock held by a 

representative investor for an average holding period, the 

decrease in the expected after-tax yield from full taxation 
of capital gaine could k offret by partial dividend relief 

with a withholding rate of only 18.1 percent. (That is, for 

each 81.9 cent6 di6tributed to rtockholdere, 18.1 cents would 

be' eligible for credit a8 corporate tax withheld, making the 

gross distribution equal to,$l). If lees than 100 percent of 

capital gains is taxed, lees offsetting dividend relief is 

required to maintain the eame after-tax rate of return. 

Similarly, full taxation of capital gains can be fully 

offset, at 1977 taxation levels, by a reduction in the 

corporate tax rate of 5.8 points, to just over 42 percent. 

The findings in this paper are similar to those of 

several leading Wall Street investment analysts who suggested 

in published reports in 3977 that the proposals in the 

Treasury working papers would not on the average lower stock 

prices. Those reports stressed possible changes in the 

relative .returns of different types of assets, noting that 

stocks held for potential appreciation (growth stocks) would 

decline in value relative to stocks with relatively high 

dividend/price ratios (yield stocks) if both full taxation of 

capital gains and partial integration were implemented. 

However, the reports did note that the beneficial effects of 

partial integration on the stock market as a whole would 

serve to counter the harmful effects of full taxation of 

capital gains. 
-5-

This paper expands on the work of the financial analysts 

by developing a framework of analysis for comparing the 

effects of changes in dividend taxation an8 capital gains 

taxation on stock prices. Quantitative estimates of the 

likely impact on stock prices t of changes in the portion of 

capital gains taxed are providedr using explicit assumptions 

about the rate of return investors require to be willing to 

invest in stocks and about the average period stocks are 

held, from purchase to sale. The framework of analysis 

developed in this paper could be used by investment analysts 

who want to perform the same computations for these or other 

tax policy changes with different assumptions about the 

required risk premium on stocks, the tax bracket of the 

representative shareholder, and the typical holding period. 

We begin by reviewing the reports of four financial 

analysts on the impact of the anticipated tax reformsr noting 

the explicit and implicit assumptions on which the 

conclusions were based. Then, we describe our own framework 

for estimating the effect of changes in tax policy on the 

value of common stock. Tables are presented showing the 

amount of integration and corporate tax rate cuts required to 

offset the decrease in after-tax return on the sale of stock 

from increased taxation of capital gains. The derivation of 

formulas used to compute the results is presented in Appendix 

A. 
-6-

Views of Financial Analyrts on TTeasUry'g preliminary 

Tax Reform Proposals 

It had been assumed in the financial community that the 

Administration tax reform proposals scheduled to be unveiled 

in late 1977 would in lude elimination of the capital gains 

preference, some form of relief of double taxation of 

dividends, and reduct on of the maximum individual tax rate 

from 70 percent to 50 percent. Some analysts also 

anticipated corporate tax rate cuts, an extension of the 

investment tax credit, and some closing of business tax 

preferences. Using these assumptions, a number of Wall 

Street financial analysts studied the probable impact of the 

prospective tax changes on financial markets. 

In general, the analysts were not alarmed by the 

expected ,tax changes. All regarded reduction of the double 

tax on dividends as a net plus for the stock market, and with 

the exception of Howard Stein of the Dreyfus Corporation -1/, 

viewed the elimination of the capital gains preference as a 

net minus. Mostly, they viewed the program as a whole as 

representing neither a strong plus nor a strong minus for the 

market 
-7-

The reports were focused on the implications of the e 

expected tax changes for relative prices of various assets. 

There was a general consensus that "yield" rrtocks would be 

helped by reduction of double taxation, while "growth" stocks 

would be hurt by the elimination of the capital gains 

preference, but there were different opinions about the 

potential effects on municipal and corporate bond markets. 

The only overall negative note in most of the analyses 

was a fear that, by creating uncertainty, advance publicity 

about major tax revision proposals may have hurt the stock 

market, and possibly depressed real investment as well. 

Generally, the analysts believed some possible ramifications 

could not be foreseen, eyen if the details of the program 

were known. The delay in revealing the Administration's 

proposal was viewed as making matters even worse. 

We briefly summarize below four reports by financial 

analysts on the prospective tax changes. 

Merrill-Lynch -2/ 

Merrill-Lynch analysts thought the entire package, 

including full taxation of capital gains and dividend relief, 

would have little effect on the return on investment in 
common stocks, At firrt, the market would fall because of 

confusion. In the long tun, the principal effect would be a 

ahift from growth rtocks to yield rtocks, The effects of 

full taxation of capital gaine and partial integration would 

cancel each other out, leaving the average level of stock 

market prices unchanged. Reducing the corporate income tax, 

increasing the investment tax credit, and allowing faster tax 

depreciation would all have a -small positive effect on stock 

prices, while eliminating DISC (Domestic International Sales 

Corporations, a tax deferral arrangement available to 

exporters) and other preferences would have a small negative 

effect. Lowering the maximum individual tax rate would have 

a positive effect on both the stock and bond markets. 

The Merrill-Lynch analysts estimated the effects on 

yields of individual stocks of four types of dividend-relief 

plans: 100 percent partial integration using the exact 

(i.e., pro-rata) method -3/, 20 percent flat rate partial 

integration, full integration, and dividend deduction. In 

all cases, it was assumed that cash dividends would remain 

fixed. This payout assumption caused the predicted increase 

in yield to be much lower with the dividend deduction method. 

However, the study did note that allowing a dividend 

deduction would create pressures for increased cash 

d iv idends , 
-9-

The Merrill-Lynch analyeis of the effects of full 

taxation of capital gains implicitly assumed that capital 

gains are rorlited every yerr. becrure 8 rhrre of stack 

typically ie 8014 every 7 to 10 yearr 1/, giving rise to 

large benefits from deferral of tax on capital gains, the 

\ 

impact of the capital gains tax is overstated by the 

Mer r il1-Lynch method . 

Mertill-Lynch analysts expressed concern that the 

Treasury program might limit capital formation by 

discouraging investment in growth stocks. 

First Boston Corporation -5/ 

First Boston analysts saw the implications for 

investment as "not all that clear," even assuming a 

reasonable guess as to what the Administration program would 

include. 

They recommended a switch from deep discount bonds to 

current coupons because of the expected ,limination of ,he 

capital gains preference, and from growth stocks to yield 

stocks. These were general observations, but were not 

advanced with great urgency. First Boston analysts suggested 

a possible switch toward stocks of high tax-rate 

corporations, on the assumption that the "exact method" of 

partial integration would be proposed. 
-10-

The Pirot Barton 8tUdy predicted that eliminating the 

capital gains preference would cause the market to go down8 

if all else remained the mame. Pressure to pay out dividends 

would increase, and business confidence, willingness to take 

risks, and productivity would be damaged. Middle-sized 

t 

companies in the risk area would be hurt the most. 

. Analysts believed discount bonds would fall in price, 

but not very much. In their "worst case" analysis, which 

assumed that the same types of taxpayers would continue to 

buy discount bonds, they described a greater than 3.5 point 

drop of telephone bonds as "mathematically preposterous," 

regarding a decline of only half a point as more likely. -

6/ 

In contrast, the study predicted that partial 

integration, all else equal, would cause the market to "take 

off." Taxable investors would shift from bonds to stock, 

causing the debt/equity ratio in corporate financial 

structures to fall. Private pension funds, State and local 

retirement plans, and foreign investors would sell yield 

stocks. If TBO (the taxable bond option, a 1978 

Administration proposal to permit, but not require, State and 

local governments to issue taxable debt with a 40 percent 

Federal interest eubsidy) were included there would be great 

pressure on State and local retirement funds to buy all 

taxable issues in their localities. In this event, Treasury 

would not gain the revenue increase anticipated from 

excluding tax-exempt8 from integration. 
-11-

Using a method similar to that of the Hertill-Lynch 

study, First Bo6tOn analyrts examined the impact on after-tax 

yield6 of the propored changer. They a180 overrtated the 

effect6 of full taxation of capital gains' by assuming that 

capital qaine are realitcd annually. $ 

First Boston also produced separate sector analyses: 

1. Commercial Banks -7/ 

Banks would gain less from partial integration than 

other companies because a larger portion of their earnings is 

from tax-exempt, tax-deferred, or foreign sources and 

therefore might not be eligible for a dividend credit. As a 

result, banks would shift to some degree out of foreign 

investments and out of tax-exempt portfolios. Fixed-income 

securities in general would become less attractive. 

2. Electric Utilities -8/ 

The 'exact method' of partiql integration would depress 

utility stock prices because utility tares are low. Dividend 

deduction would not help utilities, according to the 

analysis, because payout ratios are so high that potential 

increases in cash dividends are small. The elimination of 
-12-

the capital gains preference would have a rhort-term negative 

effect, but loreres would be mall because capital gains in 

utility rhares are not sizable. An increase in the ITC would 

be ' f avorable . 

3. Fixed Income Securities -9/ 

. Partial integration would cause a shift from debt to 

equity, depressing bond prices somewhat. Elimination of the 

capital gains preference would cause discount bonds to 

decline in price relative to current coupons (but not that 

much). If TBO were enacted, the subsidized bonds could be 

bought by tax-exempts; thus, Treasury would be subsidizing 

yields to institutions that pay no tax. . 

The First Boston report outlined other possible impacts 

and noted how exact provisions of the integration plan might 

affect markets for municipal bonds and corporate bonds. 

In summary, First Boston analysts believed the 

anticipated Treasury proposals would have no major overall 

impact on financial asset prices. Most of their analysis was 

concerned with changes in relative attractiveness among 

different types of assets (yield stocks vs. growth stocks, 

stocks vs. bonds, etc.), and they stressed the uncertainty in 

forecasting price changes. 
-13-

Dreyfus Corporation -10/ 

The Dreyfus rtudy concluded that the expected tax 

refarm progrm would have a very favorable effect on the 

stock market . 

Comparing the dividend yield to the yield on bonds, the 

latter was found to be higher for practically all stocks. 

The same comparison was made using dividends projected 5 

years in the future. Integration was shown to raise the 

after-tax yield on stocks significantly. In many cases, this 

would make the yield on stocks higher than the yield on 

bonds. Consequently, the study concluded, there would be a 

large shift of funds into, the stock market. 

The Dreyfus analyst believed that taxing capital gains 

as income would not be viewed as a deterrent. In contrast to 

the Merrill-Lynch and First Boston studies, which assumed 

that capital gains are realized every year, the Dreyfus study 

implicitly assumed that capital gains are never realized. 

Thus, the portion of capital gains included in the tax base 

would not affect an investor's prospective yield. 

The Dreyfus report concluded that "once common stock 

yields have been improved by the gross-up credits, investors 

will take in stride the abolition of the capital gains 

benefit ." 
-14-

Harilyn V. Brown -11/ 

Brown thought the impact on the economy of combining 

eome form of dividend integration with full taxation of 

capital gaine would be adverse. The program could have no 

\ 

overall effect on share price6 ifintegration offset higher 

taxes on capital gains, However, the proposal would help 

yield stocks relative to growth stocks -- a point similar to 

those stressed in the Herrill-Lynch and First Boston studies. 

According to Brown, the proposals would help large, stable 

.corporations and hurt companies that need capital to finance 

expansion. 

Brown concluded that the combination of the two measures 

a would appear to be counter to public policy for it would 

advantage companies paying dividends today while 

disadvantaging those providing the economic growth for 

tomorrow." -12/ 

Brown presents many examples illustrating the impact .-

different methods of integration and full taxation of capital 

gains would have on before-tax rates of return required to 

provide the same net yield to taxpayers in different tax 

brackets. In her examples, capital gains are treated as if 

realized every year; a'method, also used in the Merrill-Lynch 

and First Boston studies, that overstates the effects of the 

proposed changes in capital gains taxes on share values. 
-15-

Summary 

Host of the analysts raw full taxation of capital gains 

and dividend integration as having offsetting effects on the 

level of the stock market. Their analyses of the 1977 tax t 

proposals stressed changes in relative share prices, with 

yield stocks expected to rise in value and growth stocks to 

decline. The analyses generally are hedged and Some fear of 

increased uncertainty is expressed. Strikingly different 

from the others, the Dreyfus analysis expected the proposals 

in the 1977 working papers would have a very favorable effect 

on the stock market and on investment. 

Tax Policy and Stock Prices -- Another Approach to Analysis 

The single most striking feature of stock market yields 

is their great volatility through time. During the period 

1971-76, for example, average annual total returns for the 

500 stocks included in the Standard and Poors Composite Index 

varied from -26.5 percent in 1974 to +37.2 percent in 1976. 

Such fluctuations make forecasting the effect of any tax 

proposal on common stock yields extremely perilous. Indeed, 

since most of the year-to-year variation apparently is random 

with respect to underlying business and financial market 
-16-

conditions, it may not wen be porlrible to determine the 

. effects of tax policy aftet the fact. Nonethelerr, long-term 

trends in common rtock ytaldr are certainly related to yields 

of ether financial assets, to inflation rates, and to 

corporate dividend policies. Observation of these less 

\ 

volatile measures should allow inferences about the effect of 

tax policy on equilibrium common stock yields. 

In our analysis, we assume that the equilibrium rate of 

appreciation for common stocks is determined by (a) the 

after-tax rate of return from competing financial assets: (b) 

a premium for the additional risk associated with common 

stocks; (c) the recent historical ratio of dividends to share 

prices and; (d) the tax treatment of returns from common 

stock as coompared with those from other assets. 

We compared yields from alternative assets to investors 

having a 30 percent marginal rate of individual income tax. 

That tax rate was chosen because tax-exempt bonds typically 

yield about 30 percent more than fully taxable bonds of 

comparable quality. Leaving aside common stocks, taxpayers 

facing rates of 30 percent or more on additions to their 

portfolios have higher after-tax yeilds from tax-exempt 

bonds, while those paying lower rates realize greater returns 

from taxable bonds. 
-17-

However, because of the preferential treatment of 

capital gains, the tax treatment of income from common stocks 

is intermediate between that of fully taxable and tax-exempt 

securities. This suggests that the "niche" for common stocks 

is in a range of marginal tax rates around 30 percent. That 

is, the investor most likely to find common stocks attractive 

relative to either type of bond is in the 30 percent tax 

bracket. Such an investor will prefer stocks to tax exempts 

because before-tax yields on tax exempts are relatively low 

and will prefer stocks to fully taxable securities because 

the higher tax on taxable bonds more than wipes out the 

higher (risk adjusted) before-tax yield. 

Table 1 presents dat,a demonstrating an empirically 

plausible long-run equilibrium consistent with the foregoing 

discussion . 

In this example, after-tax (risk-adjusted) rates of 

return on common stocks and taxable bonds are equalized at a 

tax rate of 27 percent. As Table 1 shows, if (as was 

assumed) a premium of 1.5 percent is sufficient to equalize 

for risk, then a taxpayer facing a marginal rate of 27 

percent will be indifferent between common stock and taxable 

bonds (both have a 6.34 percent rate of return), while 

tax-exempt bonds clearly would be inferior (6.0 percent 
- 18 ­

trblo 1 

Bquilibrium Return8 for Different Taxpryerr 

t t After-Tax Rate of 

t Annual Irfore- t Return 

TYPC of Arret : Tax Rate of t 278 rrtet 30t rate : 32t rate 

: Return t taxpayer: taxpayer t taxpayer 

Taxable bond 8.57 6.34 6.0 5.57 

COmrPon 8tOck 9.5 7.84 7.65 7.50 

(After rirk 

adjurtment) A/ s (6.34) (6.15) (6.0) 

Tax-exempt bond 6.0 6.0 6.0 6.0 

-1/ Assumed differenti81 for ti8k ir 1.58. 
-19-

return). On the other hand, tax-exempt bonds and common 

stocks have equal risk adjusted yeilds when the tax rate is 

32 percent. In the range between 27 percent and 32 percent, 

common stocks have the highest yield; figures for the 30 

percent tax rate are shown in the table. The assumptions 

used in computing the after-tax return on common stock are 

discussed in the next section. 

Relative Importance of Price Appreciation and Dividends 

The before-tax common stock yield of 9.5 percent used in 

the example (Table 1) was computed by combining appreciation 

in share prices and periodic dividend distributions to 

shareholders. The relative importance of these two 

components of any projected equilibrium yield is very 

important for the analysis of the effects of tax policy for 

two reasons. First, a preferential tax rate applies only to 

appreciation. Second, the tax applied to appreciated assets 

is deferred until realization, while the tax on dividends is 

current. Thus, the effect on stock prices of a policy 

tradeoff between increased taxation of capital gains and 

varying degrees of dividend integration depends directly on 

the proportion of expected share price appreciation in the 

total return. Failure to take account of this relationship 

is the principal weakness of the studies by independent 

financial analysts summarized above. 
-20-

To project the average expected rate of rhare 

' appreciation in equilibrium we appeal to relatively rtable 

hiotorical relationrhipr. (See appenedix 8). In recent 

years, the ratio of rim of dividends to corporate 6hare 

prices has been about 4.0 percent. If this rate continues, 

$ 

an average annual price appreciation of 5.3 percent is 

required to produce a 7.65 percent total yield under present 

t.ax law. g/ In the projected equilibrium, the average share 

of etock is therefore one having the following 

characteristics: 

average annual before-tax total yield mO95, 

aver age dividend-to-,price rat io 

average annual expected rate of price 

appreciation = .053, 

average number of years between purchase 

and sale of a share = 8.0, and 

average annual after-tax yield at a 30 

percent rate of tax = .0765. 
-2 1-

This projected equilibrium has a ratio of price 

appreciation to total yield (.56) that is consistent with 

historical averages going back as much as 50 years and that 

exactly equals the average over the 25 year-period 1951-

76, -14/ as shown in appendix 8. 

t 

Tax Policy Tradeoffs between Capital Gains Treatment and 

Div id end I nteq r at ion. 

A policy to tax capital gains at full rates would reduce 

the annual after-tax yield on the average common stock just 

described from 7.65 percent to 6.97 perent (see appendix A). 

After adjustment for risk, this yield is less than that 

available from bonds at any tax rate. Shareholders paying 

marginal tax rates above 30 percent would obtain higher 

yields from tax-exempt bonds. Similarly, for taxpayers 

facing rates below 30 percent, yields from the average stock 

would fall below those from taxable bonds or high-dividend 

stocks. The equilibrium price of the average share and, for 

the same reasons, of low-dividend growth stocks, would fall 

relative to bonds and high-dividend stocks. 

A similar approach is appropriate for evaluating 

policies for relief of double taxation of dividends. 

Initially, the rate of return would rise from dividend-paying 
-22-

rtocks and in equilibrium their prices would rime relative to 

bonds and growth etocks. Tax policy will determine the size 

of this adjustment according to the rhare of corporate taxes 

allowed to be regarded by ehareholders as withholding. 

For example, in the simplest dividend relief system, the 

shareholder could be allowed to count a fixed percentage (x 

percent) of the declared dividend as tax withheld by the 

corporation on his behalf. If this amount were 20 percent, 

each dollar of declared dividend would consist of 80 cents of 

cash distribution from the corporation and 20 cents of 

withheld tax. A corporation that now pays 80 cents per share 

could pass the full amount of tax relief to shareholders by 

henceforth declaring a digidend of $1. This would leave the 

-cash dividend (and the corporate cash flow) unchanged while 

having the effect of adding 20 cents to before-tax income of 

the shareholders. This corporate behavior is assumed in the 

following analysis, although it would, of course, not be 

required. For the average common stock described earlier, 

...

the rate of withholding for dividends that just compensates 

for -full capital gains taxation, 1eaving.after-tax return 

unchanged, is 18.1 percent -

15/ (see appendix A) .
-23-

Table 2 shows five alternative tax programs that 

simultaneously would reduce the Capital gains preference 

(relative to 1977 law) and the double taxation of dividends, 

but would leave unchanged the yield from an average share of 

cc"On stock for a taxpayer facing a 30 percent marginal 

rate. -16/ 

The trade-offs shown in table 2 imply that average 

common stock prices should increase if full capital gains 

taxation were accomplished by partial integration with an 

average rate of dividend withholding in excess of 18.1 

percent. Similarly, if the portion of capital gains included 

in taxable income were increased only from 50 to 60 percent, 

partial integration with ,withholding rates as low as 5 

percent would bring a net increase in average stock 

yields. -17/ 

Any program that combines an increased capital gains tax 

and dividend relief will, of course, favor dividend-paying 

stocks relative to growth stocks. Therefore, a policy to 

leave average share yields unchanged would result in higher 

equilibrium prices for stocks having relatively high ratios 

of dividend to total yield. Conversely, such a policy would 

produce lower prices for those stocks having relatively high 

appreciation as a share of total yield. 
24 -

:: ’ Rate of Cteditable Dividend 

Rate of Inclurion :: Withholding neccrraty to leave 

Of Capital Gain8 :: 8fter-trx yield unchanged 

1008 18.18 

90t 15.08 

758 10.38 

678 6.78 

60t 4.88 

50% 0.0% 

0 
-25-

Table 3 shows, for example, that a tax program that n 

combines full taxation of capital gains and dividend 

withholding of at leaat 28.6 percent would increase 

equilibrium stock prices for all shares that have equilibrium 

dividend price ratios of at least 2.57. 

Other Policy Tradeoffs with Increased Taxation of 

Capital Gains 

An analysis similar to the foregoing can be applied to 

other tax proposals that might, on the average, fully 

compensate shareholders for increased taxation of capital 

gains. For example, if the rate of dividend payout per 

dollar of after-tax corporate earnings is not changed, then 

an increase in corporate after-tax income due to reduction 

in the corporate tax should result in a proportionate 

increase in both the dividend price ratio and the expected 

rate of share appreciation. Corporate tax reduction thereby 

could increase before-tax total yields to shareholders enough 

to reestablish the total yield after tax. 
.. .. .. 

- 26 ­

trble 3 

8ff8ct of Payout ktio on 

Dividend Belhf/Capitrl Oainr Trrdeoff 

t: 

Average 8nnua1 rate:: 

of rhare price :: 

appreciation 8: 

:: 

:: 

S.38 

6.08 

6.58 

7.58 

t: Rate of creditable 

Dividend price ::dividend withholding 

f8tfO :: nacarrraty to leave 

88' 8ftar0t8%tot81 

:: yield unchanged at 

:: 7.658 

4.08 18.18 

3.78 23.28 

2.578 28.68 

1.378 46.48 
-27-

Consider again the prospect of full inclusion of capital 

gains as ordinary income. According to the previous analysis 

this change would immediately reduce the after-tax yield of 

the average common share from 7.65 perent to 6.97 percent. A 

9 percent increase in both the dividend price ratio and the 

rate of price appreciation is sufficient to restore the 

after-tax rate of return to 7.65 percent for a shareholder 

subject to a 30 percent marginal rate of tax. This tax 

reduction could have been accomplished in 1977 by reducing 

the corporate tax rate 5.8 percentage points (from 48 percent 

and 42.2 percent). -18/ 

Table 4 shows the policy tradeoff between increased 

inclusion of capital gains in taxable income and reduction in 

corporate tax rates. Each policy combination would leave 

unchanged expected after-tax yield for a 30 percent rate 

taxpayer and the equilibrium share price unchanged for the 

average share of cormon stock. 

Conclusions 

The principal purpose of this analysis has been to 

illustrate the coriplementarity between proposals to reduce 

the capital gains preference and to relieve the double 
- 28 -

Table 4 

Corporate Tax Cut/Capital Gains Tradeoff 

Rate of Inclueion of :: Corporate Tax Rate Reduction 

Capital Gain8 in :: #eceeeary to Leave Common 

Taxable Income :: Stock Yield Conrtrnt 

Percent :: (No. of 'percentage pointe) 

60 1.3 

66 2/3 2.1 

75 

85 

100 

3.1 

1.6 

5.8 
-29-

taxation of dividends. It shows, for one plausible estimate 

of the average performance of common stock, that in 1977 a 

relatively modest amount of partial integration (a 

withholding rate of approximately 18 percent) could have 

fully compensated for full taxation of capital gains. It 

also shows that, for any level of capital gains inclusion, 

there is a companion program of double-tax relief that will 

raise equilibrium prices for -most common stocks.' As an 

alternative, reduction of the corporate income tax also could 

offset any depressing effect of increased capital gains 

taxation on stock market yields. 

Obviously, one could make different estimates of the 

characteristics of common stock in market equilibrium, which 

could alter the quantitative results. Therefore, the 

analytical framework shown here can be used by stock market 

analysts who might have different expectations about 

prospective equilibrium yields. 
-30-

FOOTNOTES 

-1/ .See Stein (1977) . 

-2/ See Hoffman, Resnick, and Ho (1977). 

3/ In the "exact" or "pro-rata" method of partial ).II 

integration, the "gross-up" allowed to shareholders of a 

corporation depends on the ratio of corporate taxes paid 

to the corporation's "economic income." In effect, 

corporate preferences are denied "pro-rata" with the 

share of economic income distributed. For a discussion 

of how partial integration with preferences "phased out" 

might work, see McLure and' Surrey (1977). 

-4/ According to data compiled from 1973 tax returns, the 

average holding period for each share of corporate stock 

sold is about 7 years. However, this understates the 

"true average" holding period because some shares are 

held indefinitely. 

.-5/ Summarized by Drill (1977) . 
-31-

-6/ See also Senft (1977). One example he cites is of a $5 

coupon bond with 25 years to maturity. If the interest 

rate is 8 percent, the capital gains rates is 30 percent 

for the marginal investor, and the ordinary income tax 

rate is 48 percent, this bond will yield the same 

after-tax return as a new bond, at a price of $73. If 

the capital gain tax preference were eliminated, the 

price of the discount bond would fall to $70.85, a drop 

of 2.15 basis points. 

-7/ See Weiant, Garvin, and Asher (1977) . 

-8/ See Barnes (1977) . 

-9/ See Senft (1977) . 

-10/ See Stein (1977) . 

-11/ See Brown (1978). 

-12/ Brown (19781, page 8. 

-13/ This is the after-tax rate of return for an individual 

who is taxed at a marginal rate of 30 percent, has no 

minimum tax liability, plans to reinvest all dividends in 
-32-

the same stock, and to sell all of these shares at the 

end of 8 years. See appendix A for a derivation. For 

nontaxable ehareholders, reinvestment of dividends would 

produce an annual return of (1.04 x lDO53-1) 

-.095. 

This is the amount of "before-tax total yield." 

-14/ These figures refer to the nominal yield on share 

purchases. The expected real yield will, of course, be 

lower if there is anticipated inflation. However, 

inflation also lowers the real yield on alternative 

financial assets, including taxable and tax-exempt bonds. 

Because under current law taxes are levied on nominal 

rather than real returns, the tax policy changes 

considered here woulcj have the same effect on relative 

asset valuations for any anticipated rate of inflation. 

-15/ Note that for versions of dividend relief other than the 

simple fixed-percentage gross-up and credit, this rate is 

the average withholding per dollar of gross dividends. 

For any given ratio of price appreciation to dividend 

yield in the total yield from stock,.there may be a 

feasible amount of dividend tax relief that will just 

equal, in present value terms, any increased tax on 

capital gains. 
-33-

-16/ If individual tax rates were also reduced, higher 

equilibrium returns would prevail for all taxable 

investment . A similar tradeoff between rtocko and bonds 

’ would st ill be applicable, however . 

-17/ Again, these results assume no change in cash 

distributions to shareholders. The tendency for share 

prices to increase would be reinforced by any tendency 

for corporations to increase dividend payout . 

-l0/ Estimated corporate income tax receipts under 1977 law 

was $71.9 billion at 1976 levels of income. Income of 

corporations after tax was $108.0 billion. An increase 

in after-tax income of 9 percent, to $117.7 billion, 

would require a tax reduction of $9.7 billion. On a 

taxable corporate income base of $168.5 billion, this 

result would require a tax reduction of 5.8 percentage 

points. This ignores the small percentage of corporate 

income for which the marginal tax rates were the normal 

rates of 20 percent and 22 percent in 1976. ~ 
-34-

REFERENCES 

Barnes, Arlene S., Electric Utilitice: Implication8 of 

Poosible Forthcorninq Tax Proporale, New York: First Boston 

Corpor.ation, September 16, 1977. 

Brown, Marilyn V., Dividend and Capital Gains Taxation 0-

Implications of Chanqinq Tax Policy. New York: Marilyn V. 

Brown Inc., 1978. 

Drill, Craig A., Tax Reform and Capital Markets: Or, a Bird 

in the Hand is Worth Two in the Bush. New York: First 

Boston Corporation, September 2, 1977. 

Hoffman, Richard J., Steven R. Resnick, and Fanny �io. 

Special Report on Coming Tax Proposals. New York: Merrill, 

Lynch, Pierce, Fenner and Smith, Inc. , Securities Research 

Division, September 1977. 

Ibbotson, Roger B., and Rex A. Sinquefield. Stocks, Bonds, 

Bills and Inflation: The Past (1926-1976) and the Future 

(1977-2000) . Chicago: Financial Analysts Research 

Foundation, 1977. 
-3 5-

Mandrakos, Leo, and Suresh L. Bhirud. Tax Reform: A 

Perspective on its Market Implications. New York: First 

Boston Corporation, August 1977. 

I 8 . I . 

McLure, Charles E., Jr., and Stanley 6. Surrey. Integration 

of Income Taxes: Issues for Debate. Harvard Business 

Review, Sept.-Oct. 1977, Vol. 55, No. 3, pp. 169-181.' 

Senft, Dexter E., Tax Reform and Implications for Fixed 

Income Securities. New York: First Boston Corporation, 

September 1977. 

Stein, Howard, Eliminating the Capital Gains Tax Would' be 

Beneficial, unpublished p,aper, October 24, 1977. 

Weiant, William M., David C. Garvin, and Livia S. Asher. -Tax

Reform Proposals and the Impact on Commercial Banks.' New 

York: First Boston Corporation, September 26, 1977. 

, ' . , ... 
-36-

Appendix A 

Calculation of the annual after-tax yield on corporate 

shares. 

Let g - annual rate of appreciation of price per share 

d = annual ratio of dividend to price, and 

t = individual income tax rate. 

Then for each share purchased at time 0, the total value of 

shares at time 1, after ceinvsstment of dividends paid a t

time 1, is: 

W+g) + l+g)d (1-t 

For simplicity, let after-tax dividends be: 

d(1-t) 2 

then, the value of shares at time 1 is: 

VI -(l+g) (l+Z) (3) 
-37-

For the purpose of computing capital gains, the basis in 

stock owned at time 1 (B1) is the sum of: (a) the original 

share at its purchase price and (b) the reinvested dividend 

at its purchase price. This amount is: 

B1 - l+(l+g)Z 

The capital value of shares and their basis at time 2 are: 

v2 = (l+g) (l+g) (1+z)+z(l+g)2 = [(l+g) (l+Z)I2 

and 

These results can be generalized to n periods as: 

vn - [(1+g)(1+z)ln 

and 

n Bn - 1+ C (l+g)i(1+2) i-lz = 1+2(1+g) n

c [ [l+g) (l+Z) I i-1 

i=l i=l 

(6b) 
-38-

Again, for simplicity, define 

which maybe interpreted as the yield before the capital gains 

tax. 

Then , 

Vn = r" and 

If all shares that have accumulated are to be sold after 

A 

n years, then the shareholder will realize an amount V, of 

after-tax capital gain. This result may be written: 

where x is the share of capital gains to be ,included in 

taxable income. We wish to compare alternative programs in 

terms of the average annual after-tax yield per share, y, 

which is given by: 
-39-

As an illustration, this paper's conclusion that full 

taxation of capital gains can be fully offset by an 18.1 

percent gross-up and credit for dividends is derived here in 

detail. The initial parameters are: 

g 0.053, 

d 0.04, 

t = 0.3, 

n = 8, and 

x = 0.5. 

Therefore , 

2 = (1-0.3)(0.04) = 0.028, 

. - and 

r = (1.028)(1.053) = 1.0825. 
-40-

Hence , 

V, - (1.0825)* = 1.8853, 

which. is the accumulated value, before capital gains tax, of 

the original one share after reinvestment of dividends. From 

equation (6b), the basis in this stock is: 

Capital gains tax is, therefore, 

Xt(Vn-Bn) = (0.5) (0.3) (1.8853 - 1.3164) = 0.0853, 

and after-tax accumulated value is: 

1.8853 - -0853 1.80. 

This gives an annual, after-tax yield (see equation 10) of: 

Y - (1.8) 0125-1-0.0765, 

the prescribed equilibrium rate of return. 

If capital gains are fully included in taxable income, 
-41­

xt(Vn-Bn) = (1,0)(.3)(1.8853 - 1.3164) 1 0.1707 

and 

, .4 

Vi = 1.8853 - 0.1707 = 1.7146. 

Thus 

y = (1.7146) *125-1= 0.0697, 

By trial and error, using equation (71, we found that 

restoring the total after-tax yield to 0.0765 requires that 

the after-tax dividend yield increase from 0.028 to 0.0342. 

Under partial dividend in,tegration, the relationship of the 

rate of dividend withholding, w, to the new after-tax 

dividend yield, 2, is: 

A 

2= . 2 

1-W 

or 

In this example, then 
-42-

w = 1- mO28 = m181, 

0342 

the dividend withholding rate (or gross-up fraction) that 

will just restore the total after-tax yield from the average 

share. 
-4 3-

Appendix B 

Historical Relationship of Price Appreciation and 

Total Return for Corporate Stocks L/ 

< Total Price Appr ec iat ion/ 

Period : return appreciation total return 

1926 - 76 9.2 4.3 .53 

1936 - 76 10.1 4.6 .55 

1946 - 76 10.6 6.5 .61 

1951 - 76 10.8 6.0 .56 

1956 - 76 7.8 4.1 .53 

1966 - 76 5.0 2.7 .54 

1971 - 76 6.4 0.9 14 

Projected 

equilibrium 2/ 9.5 5.3 .56 

Office of the Secretary of Treasury 

Office of Tax Analysis 

. 1/ Derived from data published in Roger G. Ibbotson and Rex -

A. Sinquefield, Stocks, Bonds, Bills, and Inflation: The 

Past (1926-1976) and the Future (1977-2000), Financial 

Analysts Research Foundation, 1977. These averages are 

based upon the Standard and Poor's Composite Index. 

-2/ Total return before tax is derived by multiplying the 

assumed dividend/price ratio by the expected rate of 

appreciation, (1.04) (1.053) 1.095. 

2