Effects of Dividends on Household Consumption: An Empirical Analysis, Lecture notes of Accounting

Download Effects of Dividends on Household Consumption: An Empirical Analysis and more Lecture notes Accounting in PDF only on Docsity! The Effect of Dividends on Consumption MICROSOFT’S $32 BILLION CASH dividend of December 2004 was the largest corporate payout ever. Classical models of finance and consumption-saving decisions predict that this dividend will have little effect on the consumption of Microsoft investors. Under the assumptions of Merton Miller and Franco Modigliani, for example, investors can always reinvest unwanted dividends, or sell shares to create homemade dividends, and thereby insulate their preferred consumption stream from corporate dividend policies.1 Thus, in traditional models, the division of stock returns into dividends and capital gains is a financial decision of the firm that has no “real” consequence for investor consumption patterns. Yet there are a number of reasons to think that dividend policy, and dividends more generally, may indeed affect consumption. Most obviously, the popular advice to “consume income, not principal” suggests a potentially widespread mental accounting practice in which investors do not view dividends and capital gains as fungible, as in the homemade dividends story and traditional theories of consumption, but rather place them into 231 M A L C O L M B A K E R Harvard University S T E F A N N A G E L Stanford University J E F F R E Y W U R G L E R New York University We thank Yakov Amihud, John Campbell, Alok Kumar, Erik Hurst, Martin Lettau, James Poterba, Enrichetta Ravina, Hersh Shefrin, Joel Slemrod, Nicholas Souleles, and seminar participants at the American Finance Association 2007 Meetings in Chicago and at Babson College, the University of British Columbia, the Brookings Institution, the University of Colorado, HEC, INSEAD, Imperial College (University of London), the National Bureau of Economic Research Working Group on Behavioral Finance, the New York University Stern School of Business, the Stanford Graduate School of Business, and the University of Southern California for helpful comments. We thank Terrance Odean for providing data. Malcolm Baker gratefully acknowledges financial support from the Division of Research of the Harvard Business School. 1. Miller and Modigliani (1961). 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 231 different mental accounts from which they have different propensities to consume.2 This behavior is also consistent with a belief that dividends, unlike capital gains, represent permanent income. Less exotic but equally realistic frictions, such as transaction costs (of making homemade dividends) and taxes, can also lead an investor to favor consuming dividends before capital appreciation. Although the dividends-consumption link is a potentially fundamen- tal one between corporate finance and the real economy, little empirical research has pursued the issue. The reason is probably that the most easily available data on consumption and dividends are aggregate time-series data, which have several limitations. Among other challenges, such data require one to identify the effect of a smooth aggregate dividend series using a small number of data points; they combine investors and noninvestors; and they face an essentially prohibitive endogeneity problem: omitted variables such as business conditions will jointly affect consumption, dividends, and cap- ital appreciation, making it difficult to establish the causality behind any observed correlations. This paper studies the effect of dividends on investor consumption using two micro data sets that reveal and exploit powerful cross-sectional variation in dividend receipts and capital gains. The first is the Consumer Expenditure Survey (CEX), which is a repeated cross section with data on expenditure measures and self-reported dividend income and capital gains (or losses). Our CEX sample includes several hundred households per year between 1988 and 2001. The second data set includes the trading records of tens of thousands of households with accounts at a large discount brokerage from 1991 through 1996.3 Although these portfolio data do not contain an explicit expenditure measure, they complement the CEX by allowing us to accu- rately measure net withdrawals from the portfolio, a novel dependent vari- able in its own right and a precursor to expenditure. The data set also allows us to measure the withdrawal rates of different types of dividend income, including ordinary, special, and mutual fund dividends, which allows for finer comparisons. We start with an analysis of the CEX data. Our most basic approach is to regress consumption on realized dividend income, controlling for 232 Brookings Papers on Economic Activity, 1:2007 2. Mental accounting behavior of this sort is discussed in detail in Thaler and Shefrin (1981), Shefrin and Statman (1984), and Shefrin and Thaler (1988). 3. This data set was introduced by Barber and Odean (2000). 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 232 holding their sum, total return, constant. More broadly, this study falls into a growing literature on “household finance.”7 At the end of the paper, we briefly consider what our estimates imply for the response of aggregate consumption to the May 2003 dividend tax cuts. Alternative scenarios suggest a consumption stimulus in the range of $8.3 billion to $49.9 billion, which is not insubstantial in relation to a stan- dard deviation of total personal consumption expenditure of $66 billion over the preceding five years. Evidence from the Consumer Expenditure Survey Our first data set is drawn from the Consumer Expenditure Survey, obtained from the Inter-University Consortium for Political and Social Research at the University of Michigan. The strength of the CEX is its detailed data on household consumption and demographics. Its compara- tive weakness, for our purpose, is that dividends and portfolio returns are self-reported and thus likely to be noisy. After introducing the data and definitions, we describe our empirical methodology and then present regres- sion estimates of the effects of dividends on consumption. Data and Definitions The CEX has been conducted annually by the Bureau of Labor Statistics since 1980.8 It is a short panel based on a stratified random sample of the U.S. population. Selected households are interviewed quarterly for five quarters and are then replaced by new households. As we discuss more fully below, the information on financial asset holdings and changes in these holdings over the preceding twelve months is collected in the fifth interview; data on dividends, interest received, other income variables, and demo- graphics are collected in the second and fifth interviews and cover the twelve months before the interview date. We extract most of the variables from the CEX family files, but the data on housing and credit are from the detailed expenditure files. Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 235 7. See Campbell (2006). 8. We use the average estimates in the interview survey of the CEX, not the more detailed records from the diary survey. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 235 Basic variables are as follows. We consider both expenditure on non- durable goods and total expenditure (which includes durables) as measures of consumption. A priori it is not clear which of the two consumption mea- sures is likely to be affected more strongly by dividends. On one hand, nondurables expenditure is less lumpy and could be adjusted more smoothly in response to changing dividend income than durables expenditure. On the other hand, durables consumption is more discretionary than non- durables consumption, and so the household might have more flexibility to adjust durables consumption when dividend income changes. We define nondurables consumption, C, as the sum of food, alcohol, apparel, trans- portation, entertainment, personal care, and reading expenditure.9 We use the total expenditure variable as provided in the CEX. In both cases we sum consumption over the four quarters from the second to the fifth interview. Dividends, D, are defined as (in the words of the survey ques- tion) “the amount of regular income from dividends, royalties, estates, or trusts” over the past twelve months. We also collect interest, I, received by the household. We use reported income after taxes, Y, as a proxy for total income. Total wealth, W, is the sum of home equity (property values less out- standing mortgage balances) and financial wealth. Financial wealth is the sum of balances in checking accounts, savings accounts, savings bonds, money owed to the household, and “stocks” (which includes not only holdings of stocks and mutual funds, but also corporate bonds and govern- ment bonds that are not savings bonds), minus other debt.10 Before 1988, information on the level of mortgage balances is lacking from the CEX, so we use the 1988 to 2001 data only. Also, whereas for financial assets we can measure changes over the twelve months preceding the fifth interview, for other wealth components (home equity and “other debt”) we can compute only the change over the nine months between the second and the fifth interviews. In their fifth interview survey participants are asked about the amount of securities purchased and sold over the preceding twelve months. This information allows us to decompose the change in the value of stock hold- ings into an active investment or disinvestment component and a capital 236 Brookings Papers on Economic Activity, 1:2007 9. This definition follows Parker (2001). 10. The surveys do not ask respondents to include retirement assets, but they also do not ask explicitly to exclude them, so it is unclear whether some respondents include them. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 236 gains or losses component. To compute the latter, G, we need to make an assumption regarding the timing of investment. We assume that half the reported investment was made at the beginning of the period and half at the end. We employ a few filters to screen out unusual observations. We require that there be only one consumer unit (family) in the household and that the marital status of the respondent and the size of the family remain the same from the second to the fifth interview. We delete observations where any wealth component or income is topcoded.11 We require that lagged financial wealth be positive and that a nonzero fraction of this wealth be invested in stocks or mutual funds. This last screen is the most significant: most (roughly 80 percent) of the households in the sample do not participate in the stock market. We use the consumer price index (CPI) to deflate all variables to December 2001 dollars. Summary Statistics Table 1 presents summary statistics for the CEX data. After applying the filters, we have 3,106 household-year observations. In this sample, mean nondurables consumption, reported in the top panel, is $15,042, and the median is slightly lower. Total expenditure, including durables, is three to four times as large. The next two panels report wealth and income measures. Financial wealth is typically around a third of total wealth. Total income, which includes dividends but not capital gains, has a mean of $56,566 and again a slightly lower median. Comparing the first and third panels, one sees that, on average, total income is slightly higher than total expenditure. For the households in our sample that hold some stock, average interest income is $1,264 and average dividends total $935. As one would expect, the mean capital gain of $363 is relatively small compared with total income, and its average share in total income is roughly the same as the average share of interest income. Capital gains, however, do show significant variation across households. Note that the extreme values Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 237 11. To preserve the anonymity of respondents, the CEX administrators reset observations above certain thresholds on wealth, income, and some other variables to a cutoff threshold value. Before 1995 the topcoding level was $100,000 for many items in the survey. However, since the topcoding threshold applies to single items, the total value of variables such as income after tax, for example, which is calculated as the sum of many single items, can be much larger than $100,000. After 1995, the topcoding thresholds were raised. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 237 240 Brookings Papers on Economic Activity, 1:2007 are from wealthy households with a large amount of financial wealth. What the table does not show is that capital gains also vary widely across time: virtually all of the largest negative observations, including the minimum of −$301,407, originate from 2001, where the measurement period includes the crash in technology stock prices during 2000 and 2001. The fourth panel shows that, on average, interest and dividends account for 4 percent and 2 percent of total income, respectively. The distribution is skewed, with a median household dividend income of zero. It is likely that some of the zero-dividend observations in the CEX result from underreporting of dividends by the interviewees. To ensure that our re- sults are not driven by the zero-dividend observations, we include a zero- dividend dummy variable in our regressions. Empirical Methodology The null hypothesis of interest is that capital gains and dividends are fungible, which means that households should react similarly to a change in wealth whether it comes in the form of a capital gain or in the form of a dividend. In other words, only the total return should matter, not the split of that return into dividends and capital gains or losses. To test this hypothesis, we run ordinary least squares regressions with specifications alternatively in levels, first differences, and log differences. We describe and motivate these in turn. Our basic levels specification is as follows: where Cit is household i’s consumption in period t (in this specification, consumption is summed over the four quarters preceding the fifth interview); Zit is a vector of household characteristics; Fit is a vector of financial vari- ables that includes income, lagged wealth, and interactions with Zit; Rit is the total dollar return on stocks including dividends; and Dit is total dollar dividend income. In equation 1 the total stock return is already accounted for with Rit, and therefore d = 0 under the null. However, if for some reason a household has a higher propensity to consume from dividends than from capital gains, we expect d > 0. The levels specification can be interpreted as an approximation to the consumption rule used by households. Different consumption models map income, wealth, and other household characteristics onto consumption in ( ) ,1 0 1 2C a a a gR dD uit it it it it it= + ′ + ′ + + +Z F 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 240 different ways.12 We are agnostic as to which consumption model is most accurate. Our goal is simply to distinguish between models in which capital gains and dividends are fungible and those in which the effect of dividends diverges from that of capital gains. We approximate the consumption rule with a range of variables that may be relevant for consumption decisions, allowing them to enter linearly, quadratically, and through interactions to approximate the nonlinear consumption function.13 In the end the lev- els specification boils down to asking whether two consumers in the same financial situation, with similar income, similar household charac- teristics, and similar total return on financial assets, but different compo- sitions of total returns across dividends and capital gains, have different consumption. Household characteristics in Zit include the education of the household head (dummies for high school and college graduation), the age of the household head, age of household head squared, family size, family size squared, and a set of year-month fixed effects to absorb seasonal varia- tion in consumption as well as variation in macroeconomic factors.14 Financial variables in Fit include variables that proxy for future income and for current cash on hand, including income after tax (excluding div- idends),15 lagged total wealth, lagged financial wealth, the percentage of financial wealth invested in stocks, and the squares of all these variables. We also allow for interactions of age and family size with income, lagged wealth, and lagged financial wealth. In interpreting an estimate that d > 0, the key question is whether this set of controls is sufficient or whether some omitted variable could be pos- itively correlated with dividends, thus biasing upward the estimate of d. Although all of these controls should do a reasonable job of approximating households’ consumption rule, it is difficult to fully rule out the possibility 12. Under the basic form of the permanent income hypothesis, permanent income deter- mines consumption, and so the right-hand-side variables in equation 1 matter to the extent that they are correlated with permanent income. In models of buffer-stock saving with impatience, such as those of Deaton (1991) and Carroll (1997), consumption depends on cash on hand (liquid wealth plus current income) relative to its target level. 13. This approach follows Hayashi (1985), Carroll (1994), and Parker (1999b). 14. The quarterly interviews are conducted for overlapping ends of quarters, and so we need year-month fixed effects, not simply year-quarter fixed effects. 15. The income variable does not include capital gains (realized or unrealized), so we only need to subtract dividends. In specifications where dividends plus interest is the explana- tory variable, we subtract dividends and interest. Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 241 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 241 242 Brookings Papers on Economic Activity, 1:2007 of some remaining unobserved difference between households that hold dividend-paying stocks and those that hold nonpaying stocks. Moreover, wealth and capital gains in the CEX survey are inevitably measured with error, and this sort of measurement error problem causes an upward bias in our dividend coefficient, to the extent that dividends proxy for mismeasured wealth changes. To address this omitted variables problem we also run regressions in first differences, which removes any household fixed effects that could be correlated with dividend income. Differencing is also useful for addressing an important endogeneity concern, namely, that any relationship between dividends and consumption is not causal but rather reflects the fact that households that expect to con- sume might decide ex ante to hold securities that pay the preferred consump- tion stream in the form of dividends.16 While such an “ex ante effect” would also mean that fungibility does not hold, in the sense that some consumers anticipate their unwillingness to consume from principal and adjust their portfolio accordingly, it would not imply that the composition of returns has an effect on consumption. However, to the extent that any such ex ante effect is largely a household fixed effect, with only slow time variation, differencing should help to eliminate it. Our basic differences specification is as follows:17 Since the CEX offers at most four quarterly consumption observations per household, we define ΔCit as the difference in consumption between the ( )2 0 1 2Δ Δ ΔC b b b Y D gR d Dit it it it it it= + ′ + ′ −( ) + + +Z eit . 16. See Graham and Kumar (2006) and references therein for clear evidence of divi- dend clienteles. Graham and Kumar show that the allocation to and trades of dividend- paying stocks depend on investor characteristics. 17. This is not an exact difference of the specification in equation 1. We have only a single observation per household of lagged wealth, lagged financial wealth, and capital gains, and so we are not able to compute first differences. The most notable issue is that we do not first-difference returns. Including Rt instead of ΔRt in the regression means that we are leaving a −Rt−1 term in the residual as an omitted variable. Fortunately, this should have little effect on our test, as the change in dividends from t − 1 to t is not likely to be highly correlated with Rt−1. To the extent that there is some correlation, high Rt−1 should forecast higher dividend changes from t − 1 to t as firms’ dividend policy responds with a lag to unexpected increases in profits. As a result, the −Rt−1 term in the residual is negatively cor- related with dividend changes, and hence this should lead to a downward bias on the divi- dend change coefficient. This effect would bias the test against our hypothesis. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 242 Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 245 dividends received is associated with a 16-cent difference in nondurables consumption.19 The second specification reported in table 2 includes the first lagged value of dividends, as a first step toward distinguishing between the “ex ante” (endogenous dividend-consumption clientele) and “ex post” (causal) effects that d could capture. (As mentioned previously, our main approach to deal- ing with this issue is differencing, results of which follow below.) Specif- ically, if ex ante matching of anticipated dividends and consumption were the full story, then lagged and contemporaneous dividends should have about the same correlation with current consumption. As it turns out, however, the effect of current dividends is far stronger than that of lagged dividends, consistent with a causal effect of dividends on consumption that goes beyond ex ante matching. The third and fourth specifications look at the sum of dividends and interest income, Dt + It. It seems possible that mental accounting consumers, for example, would treat interest income and dividend income similarly; likewise, spending from interest income allows households to skirt the transaction costs of selling bonds in the same way that spending from div- idends avoids the costs of selling stock. The results provide some support for these analogies, as the effect of Dt + It on consumption is similar to that of Dt. 19. Dividends in our data are measured before tax. Our regressions therefore show the relationship between before-tax dividends and consumption. If one were to use after-tax dividends, the fraction that goes into consumption would exceed 16 cents of every dollar. At the same time, however, it is also not clear how households treat taxes on dividends in a mental accounting framework. Since taxes on dividends are not withheld, the before-tax dividend cash flow and the tax payment occur at different points in time. To what extent households “integrate” the before-tax dividend cash flow with the subsequent tax payment, and to what extent it is more appropriate to view them instead as separate income streams with possibly different effects on consumption, are interesting questions. Unfortunately, we cannot answer them with the data at hand. Our focus instead is on documenting that divi- dends have an independent effect on consumption, and showing that before-tax dividends affect consumption is sufficient for that purpose. The 0.16 unit consumption effect of 1 unit of dividends could in principle be compared with the coefficient on labor income. However, in our specifications we see income and wealth variables merely as controls for all the poten- tial determinants of households’ consumption rule that could be correlated with dividends. We would prefer not to claim that we have a complete and correct model that would deliver the marginal propensity to consume out of income. Nonetheless, for the interested reader, the total effect of current and lagged income is 0.18 in regressions 2-1 and 2-2, 0.71 in regression 2-5, and 0.70 in regression 2-6. So the effect of after-tax labor income is in the same range as that of before-tax dividends. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 245 The last four specifications in table 2 use total expenditure as the depen- dent variable. The estimated coefficients on Dt and Dt + It are roughly four to five times those in the regressions with nondurables consumption on the left-hand side. As total expenditure is proportionally higher than non- durables consumption, on average these results suggest that dividend income is not used exclusively for nondurables consumption but rather boosts expenditure of all types. In all other respects, the results in these specifi- cations are similar to those for nondurables. It is interesting that no evidence emerges of a significant effect of cap- ital gains; indeed, all the point estimates on total returns are negative. Of course, a low (but positive) propensity to consume capital gains would not have been surprising. Under the permanent income hypothesis, for instance, forward-looking consumers spread the consumption from an unexpected increase in wealth over their lifetime, so that the coefficient on total returns is predicted to be on the order of the real interest rate. From this perspective, what is striking about the results in table 2 is the far higher consumption from the return component that we label “dividends.” The very large effects of dividends on total expenditure, in particular, strongly suggest that individuals consume dividends disproportionately in the period in which they are received. Table 3 reports estimates of equation 2. The first specification includes total returns, the change in dividends, and other controls, including a dummy for zero dividends over the preceding and current twelve-month periods and, in some specifications, lagged consumption. Since we are regressing the change in quarterly consumption (from the second to the fifth interview) on changes in dividends measured over twelve-month periods (preceding the second and fifth interviews), one would expect the coefficient estimates on ΔDt to be about one quarter of those on Dt in the levels specifications. The results indicate that multiplying the coefficient estimates on ΔDt by four does yield numbers that are at least of the same order of magni- tude as the estimates in table 2, although somewhat lower, in particular for the nondurables specifications. The moderate decrease is consistent with some ex ante effect in the levels estimates, but it could also reflect the noise introduced through the imperfect matching of dividends and consumption measurement periods. Consistent with the latter possibility, controlling for lagged consumption, which should absorb some of the noise, raises the magnitude of the coefficient on dividend changes. But 246 Brookings Papers on Economic Activity, 1:2007 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 246 T ab le 3 . R eg re ss io ns o f C on su m pt io n on D iv id en ds , T ot al R et ur ns , a nd O th er S ou rc es o f In co m e U si ng C on su m er E xp en di tu re Su rv ey D at a in F ir st D if fe re nc es a D ep en de nt v ar ia bl e C ha ng e in n on du ra bl es e xp en di tu re b C ha ng e in to ta l e xp en di tu re In de pe nd en t v ar ia bl e 3- 1 3- 2 3- 3 3- 4 3- 5 3- 6 3- 7 3- 8 T ot al r et ur n on s to ck s (R t = G t + D t)c −0 .0 03 −0 .0 02 0. 00 6 0. 00 4 (0 .0 03 ) (0 .0 03 ) (0 .0 08 ) (0 .0 08 ) C ha ng e in d iv id en ds ( ΔD t)d 0. 01 7 0. 00 5 0. 09 3 0. 05 7 (0 .0 09 ) (0 .0 10 ) (0 .0 29 ) (0 .0 28 ) D um m y va ri ab le = 1 w he n D t = D t− 1 = 0 −2 79 −1 27 −8 50 −8 33 (9 2) (1 10 ) (2 56 ) (2 55 ) C ha ng e in in co m e le ss d iv id en ds ( Δ[ Y t − D t ]) d −0 .0 01 0. 00 0 0. 02 5 0. 03 4 (0 .0 03 ) (0 .0 04 ) (0 .0 07 ) (0 .0 08 ) T ot al r et ur n (R t = G t + D t + I t) −0 .0 04 −0 .0 04 0. 00 3 0. 00 2 (0 .0 03 ) (0 .0 04 ) (0 .0 09 ) (0 .0 09 ) C ha ng e in d iv id en ds p lu s ch an ge in in te re st 0. 00 9 0. 00 7 0. 05 6 0. 05 6 (Δ D t + ΔI t)d (0 .0 08 ) (0 .0 08 ) (0 .0 28 ) (0 .0 28 ) D um m y va ri ab le = 1 w he n D t + I t = D t− 1 + I t− 1 = 0 −2 68 −7 8 0 −7 32 (1 05 ) (1 27 ) (0 ) (2 77 ) C ha ng e in in co m e le ss d iv id en ds a nd in te re st −0 .0 02 0. 00 0 0. 02 8 0. 03 9 (Δ [Y t − D t − I t ]) d (0 .0 04 ) (0 .0 04 ) (0 .0 08 ) (0 .0 10 ) C on su m pt io n la gg ed o ne p er io d (C t− 1) −0 .6 78 −0 .7 03 −0 .6 21 −0 .6 27 (0 .0 47 ) (0 .0 49 ) (0 .0 41 ) (0 .0 45 ) N o. o f ob se rv at io ns 2, 79 6 2, 79 6 2, 41 0 2, 41 0 2, 79 6 2, 79 6 2, 41 0 2, 41 0 R 2 0. 38 0. 06 0. 39 0. 06 0. 37 0. 07 0. 39 0. 08 S ou rc e: A ut ho rs ’ re gr es si on s us in g C on su m er E xp en di tu re S ur ve y da ta . a. T he d ep en de nt ( co ns um pt io n) v ar ia bl es a re d efi ne d as th e di ff er en ce b et w ee n qu ar te rl y co ns um pt io n in th e fif th ( an d la st ) in te rv ie w a nd th at in th e se co nd in te rv ie w th re e qu ar te rs e ar lie r. A ll re gr es si on s in cl ud e ye ar -m on th fi xe d ef fe ct s an d ho us eh ol d co nt ro ls ( fa m ily s iz e an d hi gh s ch oo l e du ca tio n, c ol le ge e du ca tio n, a nd a ge o f re sp on de nt ) an d th e fo llo w in g in te ra ct io ns : h ig h sc ho ol e du ca tio n × ag e, c ol le ge ed uc at io n × ag e, fa m ily s iz e × ag e, a ge s qu ar ed , a nd fa m ily s iz e sq ua re d. N um be rs in p ar en th es es a re h et er os ke da st ic ity -r ob us t s ta nd ar d er ro rs . A ll va ri ab le s in d ol la rs a re d efl at ed b y th e co ns um er p ri ce in de x. b. C on su m er n on du ra bl es e xp en di tu re is d efi ne d as in ta bl e 1. c. T ot al r et ur ns a re m ea su re d ov er th e fo ur q ua rt er s be fo re a h ou se ho ld ’s fi ft h in te rv ie w . d. D if fe re nc e be tw ee n an nu al in co m e it em s re po rt ed a t t he fi ft h in te rv ie w a nd th e se co nd in te rv ie w th re e qu ar te rs e ar li er . T hi s va ri ab le is o nl y an a pp ro xi m at io n of th e fi rs t d if fe re nc e be ca us e in co m e is m ea su re d af te r ta x w he re as d iv id en ds a re m ea su re d be fo re ta x. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 247 250 Brookings Papers on Economic Activity, 1:2007 As an additional robustness check, we have also removed capital gains outliers from the regression. In a survey like the CEX, which is based on self-reported information, the capital gains data are likely to have substan- tial measurement error. We want to ensure that the absence of a capital gains effect on consumption is not caused by a few large and potentially erroneous outliers. Winsorizing capital gains at their 5th and 95th per- centiles, however, results in quantitatively similar estimates.20 Perhaps more important, winsorizing the capital gains data leaves the coefficients on dividends virtually unaffected. Overall, it seems that the results are not unduly influenced by outliers. In summary, the best available U.S. micro data on consumption suggest that controlling for total returns, dividends have a significant effect on consumption. The relationship is generally robust across specifications in levels, simple differences, and log differences. Evidence from Household Portfolios As already mentioned, a concern with the self-reported CEX data is that dividends and capital gains are likely to be measured with substantial error. It is not clear to what extent measurement error influences the foregoing results. Furthermore, the results would be made even more persuasive if we could verify the intermediate, mechanical step between receipt of div- idends and consumption expenditure—that dividends are in fact withdrawn from brokerage accounts, and at a higher rate than capital gains. Our second micro data set, based on household portfolios, achieves these objectives and thus complements the CEX data. Furthermore, it allows us to study net withdrawals from investment portfolios, an interesting and novel dependent variable in its own right.21 Finally, the larger sample size and detail of the portfolio data allow for certain robustness tests and sample splits that are not possible in the CEX data. 20. Winsorizing replaces all observations in the tails of the distribution (in this case the top and bottom 5 percent) with the observed values at the 5th and the 95th percentiles, respectively. In the base case nondurables regression (regression 2-1) in table 2, the coeffi- cient on the total return drops to −0.02 with a standard error of 0.02. In the base case total expenditure regression (regression 2-5) in table 2, the coefficient rises to 0.01 with a stan- dard error of 0.04. 21. In a paper that is similar in spirit, Choi and others (2006) use shifts in savings into 401(k) plans to identify changes in consumption. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 250 Data and Definitions Our household portfolio data set contains monthly position statements and trading activity for a sample of 78,000 households with accounts at a large discount brokerage firm.22 To enter the sample, households were required to have an open account during 1991. For the sampled households, posi- tion statements and accounts data were gathered for January 1991 through December 1996. The full data set covers all accounts, including margin and retirement accounts, opened by each sampled household at this brokerage. For our sample we exclude margin accounts, Individual Retirement Accounts (IRAs), Keogh accounts, and accounts that are not joint tenancy or indi- vidual accounts. Securities followed include common stocks, mutual and closed-end funds, American depository receipts, and warrants and options held in these accounts. We focus on common stocks and mutual funds, which represent all, or nearly all, of most households’ portfolios. We use household-month level observations on net withdrawals, port- folio value, capital gains, and total dividends. Net withdrawals C (we use C in analogy to our earlier definitions, although, to be precise, we are not studying consumption but rather net withdrawals in this data set) are inferred as the starting value of portfolio assets A, plus capital gains G, plus dividends D, minus the ending value of the portfolio. That is, for household i, where the components that can be directly estimated include total portfolio value, defined as the product of price P and quantity Q held in investment j and summed across investments, capital gains, where prices are adjusted for stock splits; and total dividend income, where Djt is dividends paid per share of investment j. ( ) ,6 1D Q Dit jt jt j = −∑ ( ) ,5 1 1G Q P Pit jt jt jt j = −( )− −∑ ( ) ;4 A Q Pit jt jt j = ∑ ( ) ,3 1C A G D Ait it it it it= + + −− 22. See Barber and Odean (2000) for more details about the data set. Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 251 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 251 252 Brookings Papers on Economic Activity, 1:2007 For simplicity, we suppress the household i subscript on per-share quanti- ties, prices, and dividends. To estimate these quantities from the brokerage data, we pool each household’s accounts to obtain positions and trades by household-month. The brokerage data do not directly identify dividend income; we match portfolio holdings to the stock file of the Center for Research in Securities Prices (CRSP) database to measure dividends on common stocks, and to the CRSP mutual fund file to measure dividends on mutual funds. For each stock and mutual fund in a household’s portfolio at the beginning of the month, we use the monthly CRSP data on dividend distributions to calcu- late the dollar amount of dividends received during that month. We assume that each household holds until the end of the month the securities in its portfolio at the beginning of the month. For common stock dividends, we use CRSP distribution codes 1232, 1212, 1218, 1222, and 1245 to identify ordinary dividends, and 1262 and 1272 to identify special dividends.23 We then total the dollar amounts of stock and mutual fund dividends across all stocks and funds in the portfolio to get a monthly measure of dividends. The data contain outliers due to account openings and closings that do not reflect actual consumption and saving decisions. We exclude household- month observations where we cannot identify a CRSP mutual fund or common stock match for at least 75 percent of the account value at month t − 1, and we exclude households where the account value falls below $10,000, or dividends are missing in any of the months t to t − 11. This leaves 93,312 household-months of data on lagged account value, dividends, capital gains, and net withdrawals. These data still contain some outliers; for instance, the minimum value for net withdrawals as a percentage of lagged account value is −2,807.7, indicating a very large net inflow of funds in that portfolio. To prevent a few such data points from driving results, we exclude household-months in which net withdrawals exceed 50 percent in absolute value. This screen excludes about 0.96 percent of the sample.24 The final sample includes 92,412 household-months. 23. This method follows DeAngelo, DeAngelo, and Skinner (2000). 24. The results below are robust to choosing different cutoffs. For example, they are quan- titatively similar when 5 percent or 0.5 percent of the most extreme observations are eliminated. But some deletion of outliers is necessary: the most extreme single observation would other- wise account for about one-third of the sum of squared net withdrawals (even though there are close to 100,000 observations in total), making any regression analysis practically meaningless. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 252 Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 255 ing for almost all of the remainder. Special dividends are rare but can be very large when they do occur. Effects of Dividends and Capital Gains on Net Withdrawals Figure 1 is a scatterplot of household-month observations of net with- drawals against contemporaneous total dividends. The figure clearly shows two modal behaviors with respect to dividend income. The clustering of points along a line indicating a one-for-one increasing relationship between net withdrawals and dividends suggests that many investors follow a “zero (contemporaneous) reinvestment” policy; the clustering of points along a second line indicating a flat relationship suggests that many other 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 −2 −1 0 1 2 Net withdrawals (percent of total assets)b Dividends (percent of total assets)b Source: Authors’ calculations using data from Barber and Odean (2000). a. Each observation represents activity (net withdrawals and contemporaneous dividends) in the brokerage account of a single household in a single month. Only household-month observations with positive dividends are included. b. In period t – 1. Figure 1. Net Withdrawals versus Dividends Received by Individual Household Accounta 10657-04a_Baker.qxd 8/16/07 11:39 AM Page 255 256 Brookings Papers on Economic Activity, 1:2007 investors have an “automatic reinvestment” policy. The many thousands of observations that lie on neither line suggest a weakly positive relation- ship more generally. An analogous scatterplot of net withdrawals as a function of capital gains (not shown) reveals no visible patterns. Figure 2 plots median and mean responses to dividend payouts. In the top left panel, dividend income is broken down into eleven groups, one for household-months with no dividend income and ten deciles for those with positive dividends. Within each group we plot median net withdrawals against median total dividends. The results suggest that the median house- Percent of total assetsb Source: Authors’ calculations using data from Barber and Odean (2000). a. Data for household-months with positive dividends are sorted into deciles according to the value of monthly dividends (top two panels) or total returns (bottom two panels); for the top two panels, an eleventh group consists of household-months with no dividends; median or mean net withdrawals is then computed for each group. b. All data are expressed as a percent of household total assets in period t – 1. Median net withdrawals versus total returns Total returns –0.2 –0.1 0 0.1 0.2 –10 Net withdrawals –5 0 5 10 Mean net withdrawals versus total returns Total returns –0.1 –0.2 0 0.2 0.1 Net withdrawals –10 –5 5 100 Median net withdrawals versus dividends Dividends 0.0 0.5 1.0 Net withdrawals 0.5 1.0 1.5 Mean net withdrawals versus dividends 0.0 0.5 1.0 Dividends Net withdrawals 0.5 1.0 1.5 Figure 2. Net Withdrawals of Dividends versus Dividends Received and Total Returns, by Decilea 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 256 hold does not immediately reinvest moderate-size dividends: net withdrawals increase one for one with dividend income over the bottom several deciles; that is, in this range the first of the two modal behaviors noted in figure 1 is also the median behavior. The top right panel of figure 2 depicts the mean responses to dividend payouts. We show mean net withdrawals for the zero-dividend group and for the mean level of dividends within each of the ten positive-dividend deciles. The figure again shows a positive relationship between dividends and net withdrawals. Note that the mean behavior is to contemporaneously withdraw most, but not all, of a relatively large dividend. (This could be consistent with a mental accounting practice in which the large dividends that result from cash acquisitions, for example, are treated not like ordinary dividends but rather as principal to be reinvested.) The bottom two panels provide an initial look at the effect of total returns, again at the median and at the mean. The contrast with the picture for div- idends confirms the CEX results: the effect of total returns appears to be much smaller. The bottom left panel shows that regardless of the level of total returns, the median contemporaneous net withdrawal is zero. The bottom right panel shows that, at the mean, very large total returns engender net withdrawals, and very low total returns net inflows. There is no clear effect in the intermediate range. Table 6 reports regression estimates of the effects of contemporaneous dividends and total returns on the rate of withdrawals. The first three specifications include linear effects only; we then confirm the additional structure suggested in the figures using a piecewise linear specification. Specifically, we allow for a differential effect when dividends are in the top decile and a differential effect when total returns (primarily capital gains) are smaller than 2.5 percent in absolute value. Again suppressing the household i subscripts, It may be helpful to interpret the coefficients explicitly. Regression 6-1 indicates that, on average, investors have a propensity to contemporane- ously withdraw dividends of about 0.35. Regression 6-2 shows an average ( ) %7 90 1 1 1 2 1 1 C A a d D A d D A D A ilet t t t t t t t− − − − = + + >⎧ ⎨ ⎩ ⎫ ⎬ ⎭ + + <⎧ ⎨ ⎩ ⎫ ⎬ ⎭ + − − − r R A r R A R A t t t t t t 1 1 2 1 1 0 025. vt . Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 257 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 257 260 Brookings Papers on Economic Activity, 1:2007 In this specification, when the monthly total return is greater than 2.5 per- cent in absolute value, the long-run propensity to withdraw capital gains is (r1 + r3). When smaller, the long-run propensity is (r1 + r2 + r3 + r4). Likewise, the differential or “extra” long-run propensity to withdraw a small or medium-size dividend income realization is (d1 + d3), and the differen- tial long-run propensity to withdraw a top-decile dividend realization is (d1 + d2 + d3 + d4). Note that in this setup any effect of delayed reinvestment shows up empirically as a negative estimate for d3 and d4 for dividends (r3 and r4 for capital gains), because dividends or capital gains that are reinvested will be detected as reduced net withdrawals as a function of the lagged variable.26 Table 7 shows that allowing for the possibility of a full year of delayed reinvestment does not alter earlier inferences about the effects of dividends. In the simple linear regressions (7-1 through 7-3), the contemporaneous coefficients are as before, and the effects of lagged dividends are nil. The full piecewise linear model (regression 7-6) shows that the long-run propen- sity to withdraw small or medium-size dividends is 0.73 (0.80 − 0.07) greater than that of total returns, statistically indistinguishable from the 0.77 gap in the short-run propensities to withdraw that we found in table 6, and thus indicating little or no reinvestment. On the other hand, the differ- ential long-run propensity to withdraw very large dividends is still pos- itive, but considerably smaller, at 0.33 (0.80 − 0.47 − 0.07 + 0.07), which is also the same as the estimate we obtained without allowing for delayed reinvestment. Finally, there is little evidence that capital gains engender reinvestment. Thus accounting for delays in reinvestment does not change the con- clusion that there is a large difference in the propensities to withdraw dividends and capital gains. Unless households in this sample are out of steady state, systematically accumulating cash balances (and doing so out of dividends, not capital gains), the results are consistent with the notion that a substantial portion of dividend income is permanently withdrawn to finance consumption. 26. In principle, one could also include individual lags of Dt and Rt instead of the sum- mation terms, and then sum the estimated coefficients on the individual lags to calculate the total effect of delayed reinvestment. The approaches are equivalent when Dt and Rt and their lags, respectively, are uncorrelated. In our data these correlations are low, so both approaches lead to similar results. For simplicity, we report results from the summed lags approach. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 260 Household Characteristics To check the robustness of our results, we split the sample across several household and portfolio characteristics (table 8). First, we split by portfolio size. These accounts are believed to typically represent a rather small frac- tion of the household’s net worth, but for about a fifth of the sample we have self-reported data on net worth and tax rates supplied to the brokerage firm when the account was opened, so we can test whether the results extend to households for which the portfolio represents at least half of reported net worth. Second, we split by net worth itself. Third, we split by marginal income tax rate, which is obviously also a proxy for income. Fourth, we split the sample by portfolio turnover. Table 7. Regressions of Net Brokerage Withdrawals on Dividends and Total Returns Controlling for Effect of Delayed Reinvestmenta Dependent variable is net withdrawals as share of previous-period assets and regressions are Linear Piecewise linear Independent variable 7-1 7-2 7-3 7-4 7-5 7-6 Dividends as share 0.35 0.35 0.81 0.80 of previous-period (0.09) (0.09) (0.10) (0.10) assets (Dt /At−1) Dt /At−1 × dummy = 1 if −0.48 −0.47 Dt /At−1 > 90th percentile (0.12) (0.12) Average of 11 monthly 0.01 0.01 −0.16 −0.07 lags of dividends/assets (0.10) (0.10) (0.17) (0.18) (1⁄11 Σs=1 to 11 Dt-s/At-1) 1⁄11 Σs=1 to 11 Dt-s/At−1 × 0.14 0.07 dummy = 1 if Dt-s/At−1 (0.18) (0.18) > 90th percentile Total returns as share 0.02 0.02 0.02 0.02 of previous-period (0.00) (0.00) (0.00) (0.00) assets (Rt /At−1) Rt /At−1 × dummy = 1 if −0.03 −0.04  Rt /At−1  < 0.025 (0.02) (0.02) 1⁄11 Σs=1 to 11 Rt-s /At−1 0.00 0.00 0.00 0.00 (0.01) (0.01) (0.01) (0.01) 1⁄11 Σs=1 to 11 Rt-s /At−1 × dummy = 1 0.03 −0.06 if  Rt-s/At-1  < 0.025 (0.06) (0.06) R2 0.0025 0.0005 0.0029 0.0027 0.0005 0.0032 Source: Authors’ regressions using data from Barber and Odean (2000). a. All data are in percent. All regressions include an intercept (not reported). Heteroskedasticity-robust standard errors are in parentheses. Data on household net worth and tax rate are self-reported and were supplied to the brokerage firm at the time the account was opened. The sample in each regression consists of 92,412 observations. Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 261 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 261 T ab le 8 . Sp lit -S am pl e R eg re ss io ns o f N et B ro ke ra ge W it hd ra w al s on D iv id en ds a nd T ot al R et ur ns a D ep en de nt v ar ia bl e is n et w ith dr aw al s as s ha re o f p re vi ou s- pe ri od a ss et s an d sa m pl e is s pl it ac co rd in g to H ou se ho ld p or tf ol io v al ue > H al f o f In de pe nd en t v ar ia bl e < M ed ia n > M ed ia n ne t w or th < M ed ia n > M ed ia n < M ed ia n > M ed ia n < M ed ia n > M ed ia n D iv id en ds a s sh ar e of p re vi ou s- 0. 77 0. 80 0. 84 0. 67 0. 81 0. 44 1. 00 0. 75 0. 89 pe ri od a ss et s (D t /A t− 1) (0 .1 2) (0 .1 3) (0 .4 3) (0 .3 2) (0 .3 6) (0 .2 9) (0 .4 0) (0 .0 7) (0 .1 9) D t/A t− 1 × du m m y = 1 if D t /A t− 1 −0 .4 3 −0 .4 8 −0 .5 4 −0 .1 6 −0 .7 2 −0 .3 2 −0 .5 7 −0 .4 5 −0 .5 2 > 9 0t h pe rc en ti le (0 .1 5) (0 .1 6) (0 .4 4) (0 .3 2) (0 .3 6) (0 .3 0) (0 .4 1) (0 .1 1) (0 .2 1) T ot al r et ur ns a s sh ar e of p re vi ou s- 0. 02 0. 02 0. 01 0. 02 0. 02 0. 04 0. 00 0. 01 0. 03 pe ri od a ss et s (R t /A t− 1) (0 .0 0) (0 .0 0) (0 .0 1) (0 .0 1) (0 .0 1) (0 .0 1) (0 .0 1) (0 .0 0) (0 .0 1) R t /A t− 1 × du m m y = 1 if 0. 00 −0 .0 8 −0 .0 2 −0 .0 7 −0 .0 1 −0 .0 7 −0 .0 1 −0 .0 2 −0 .0 7 R t /A t− 1 < 0 .0 25 (0 .0 3) (0 .0 3) (0 .0 8) (0 .0 6) (0 .0 7) (0 .0 6) (0 .0 8) (0 .0 2) (0 .0 4) N o. o f ob se rv at io ns 45 ,0 92 47 ,3 20 6, 24 0 11 ,9 47 7, 97 3 11 ,7 68 8, 15 2 48 ,3 53 44 ,0 59 R 2 0. 00 42 0. 00 26 0. 00 12 0. 00 35 0. 00 10 0. 00 21 0. 00 26 0. 00 62 0. 00 29 S ou rc e: A ut ho rs ’ re gr es si on s us in g da ta f ro m B ar be r an d O de an ( 20 00 ). a. A ll d at a ar e in p er ce nt . A ll r eg re ss io ns in cl ud e an in te rc ep t ( no t r ep or te d) . H et er os ke da st ic it y- ro bu st s ta nd ar d er ro rs a re in p ar en th es es . H ou se ho ld n et w or th H ou se ho ld ta x ra te H ou se ho ld p or tf ol io tu rn ov er 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 262 Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 265 whereas the point estimates suggest that large special dividends are mostly reinvested. Reverse Causality Like the CEX results, the above results may be affected by an endogeneity problem. Some households may have chosen their ordinary-dividend-paying stocks and, to a lesser extent, their mutual funds ex ante in anticipation of consuming the dividends. If so, the evidence presented so far is insufficient to demonstrate that dividends, particularly ordinary dividends, have a causal effect. For the ex ante effect to dominate, there would have to be a large pre- dictable component in dividends such that it is feasible for households to match desired future consumption with anticipated dividend streams. Unlike Net withdrawals (percent of total assets)b Special dividends Dividends (percent of total assets)b 0.5 1.0 1.5 2.0 2.5 −4 −3 −2 −1 0 1 2 3 4 Source: Authors’ calculations using data from Barber and Odean (2000). a. Each observation represents activity (net withdrawals and contemporaneous dividends) in the brokerage account of a single household in a single month. Only household-month observations with positive dividends are included. b. In period t – 1. Figure 3. Net Withdrawals versus Dividends Received by Individual Household Account, by Type of Dividenda (Continued) 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 265 Percent of total assetsb Source: Authors’ calculations using data from Barber and Odean (2000). a. Data for household-months with positive dividends are sorted into deciles according to the value of monthly dividends of various types; an eleventh group consists of household-months with no dividends; median or mean net withdrawals is then computed for each group. b. All data are expressed as a percent of household total assets in period t – 1. c. All dividends other than ordinary or mutual fund dividends; includes special dividends, liquidating dividends, and cash acquisitions. Median net withdrawals versus mutual fund dividends Mutual fund dividends 0.0 0.5 1.0 0.5 Net withdrawals 1.0 1.5 2.0 Mean net withdrawals versus mutual fund dividends Mutual fund dividends 0.0 0.5 1.0 Net withdrawals 1.0 3.02.0 Median net withdrawals versus special dividendsc Mean net withdrawals versus special dividends Special dividendsc 0 10 5 15 20 5 Net withdrawals 10 15 20 25 Special dividends 0 10 5 20 15 Net withdrawals 10 3020 Median net withdrawals versus ordinary dividends Ordinary dividends 0.0 0.5 1.0 Net withdrawals 0.2 0.4 0.6 0.8 1.0 Mean net withdrawals versus ordinary dividends 0.0 0.5 1.0 0.2 Ordinary dividends Net withdrawals 0.4 0.6 0.8 1.0 Figure 4. Net Withdrawals versus Dividends Received, by Type of Dividend and Decilea 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 266 Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 267 in our CEX analysis, dividends here are scaled by portfolio value, which already reduces a potential source of cross-sectional predictability. As it turns out, scaled dividends in total (the sum of ordinary, mutual fund, and special dividends) are unpredictable from lagged dividends (that is, almost all variation is “unexpected”): twelve months of lagged dividends explains only 4 percent of the variation in scaled dividends in the current month. Hence reverse causality is empirically not a major concern in the total- dividends results that we reported above, unless we are to believe that investors are rapidly rebalancing their portfolios in anticipation of chang- ing consumption needs. Ordinary dividends on their own (scaled by beginning-of-period port- folio value), however, are highly predictable, with the one-year-lagged value explaining 57 percent of the variation in ordinary dividends, and the one-year- and three-month-lagged values together explaining 81 percent. Mutual fund dividends are less predictable, with the one-year-lagged value explaining 43 percent and the three-month-lagged value (as expected) Table 9. Regressions of Net Brokerage Withdrawals on Dividends of Different Types and Total Returnsa Dependent variable is net withdrawals as share of previous-period assets and dividends are Special Ordinary Mutual fund and other Independent variable 9-1 9-2 9-3 9-4 9-5 9-6 Dividends as share 0.82 0.71 0.40 0.35 0.75 0.75 of previous-period (0.11) (0.13) (0.12) (0.14) (0.13) (0.13) assets (Dt/At−1) Dt/At−1 × dummy = 1 if 0.16 0.16 −0.26 −0.23 −0.46 −0.46 Dt /At−1 > 90th percentile (0.12) (0.12) (0.13) (0.13) (0.19) (0.19) Total returns as share 0.02 0.02 0.02 0.02 0.02 0.02 of previous-period (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) assets (Rt/At−1) Rt /At−1 × dummy = 1 if −0.02 −0.02 −0.04 −0.04 −0.03 −0.03  Rt /At−1 < 0.025 (0.02) (0.02) (0.02) (0.02) (0.02) (0.02) Ratio of 12-month lag 0.13 0.05 −0.08 of dividends to total (0.09) (0.06) (0.04) assets (Dt−12/At − 1) R2 0.0023 0.0023 0.0007 0.0007 0.0021 0.0022 Source: Authors’ regressions using data from Barber and Odean (2000). a. All data are in percent. All regressions include an intercept (not reported). Heteroskedasticity-robust standard errors are in parentheses. The sample in each regression consists of 92,412 observations. 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 267 270 Brookings Papers on Economic Activity, 1:2007 unwanted dividends at little, if any, marginal cost; in other words, again, the transaction costs are not binding.28 Taxes Perhaps investors fail to fully reinvest dividends (that is, have a higher propensity to withdraw them) because they regularly withhold a portion for federal and state taxes. Of course, taxes can be paid from any source, and so this story is already founded on mental accounting. Table 8 shows that high-tax households are more likely than low-tax households to withdraw dividend income. In fact, the difference between the two groups is much too large (although standard errors are also large) to attribute to differential taxation: higher-tax households withdraw 100 per- cent of their small and medium-size dividends, far more than they would need to cover taxes. Another tax consideration is the higher tax rate on dividend income than on capital gains that prevailed in our sample period. Perhaps households made mistakes ex ante in buying the highly taxed dividend-paying assets, or purchased them at a discount, and ex post, given their holdings, it makes sense to finance consumption through dividends rather than capital gains. But, to develop this same idea further, many households in our sample have individual stocks with accumulated capital losses at any given time, and so from an ex post tax perspective these households should consume from realized losses even before dividends. Yet empirically the evidence indi- cates that investors are more likely to sell winners than losers in every month except December.29 Different “Permanence” of Dividends and Capital Gains The results might yet be reconciled with fully optimizing, forward-looking behavior if stock returns have permanent and transitory components. In our regressions we control for total returns, and so dividends do not add any additional information about the size of wealth shocks. But if changes in dividends are more strongly correlated with the permanent component of stock returns than with the transitory component, changes in dividends 28. See Odean (1999) and Barber and Odean (2000) for more general arguments that investors trade too much and fail to properly consider transaction costs. 29. See Odean (1998). 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 270 could provide some information about the permanence of wealth shocks.30 In this case one would expect dividends to be correlated with consumption even after controlling for total returns. At the level of the aggregate market, such an explanation could have relevance, although it would be difficult to distinguish it from other expla- nations such as mental accounting. A large proportion of the variation in market-level returns appears to be transitory, driven by temporary move- ments in discount rates.31 There is also empirical support for the idea that aggregate consumption responds more to permanent than to transitory changes in asset values.32 However, our results are driven by cross-sectional, not aggregate vari- ation in returns and dividends. This is an important difference, because movements in discount rates are systematic, driven by macroeconomic variables. As a result, the variation in returns induced by changes in dis- count rates is, to a large extent, a common component across stocks.33 The time fixed effects in our regressions absorb aggregate movements in asset values, leaving the market-adjusted and largely permanent component of returns. Thus differences in the permanence of dividends and capital gains also cannot explain our results. Mental Accounting Finally, a higher propensity to consume from dividends than from cap- ital gains is predicted by typical mental accounting theories. Indeed, Hersh Shefrin and Richard Thaler explicitly describe such a higher propensity as an important (but as yet untested) prediction of their mental accounting framework.34 30. Note that the issue of permanence of wealth shocks correlated with dividends is unrelated to the issue of whether companies set dividends equal to the permanent compo- nent of earnings. It is perfectly possible for a company’s earnings to have a strongly transi- tory component while its stock returns are entirely permanent, and vice versa. The relevant issue here is the permanence of stock returns, not of earnings. 31. See Poterba and Summers (1988), Fama and French (1988), and Campbell and Shiller (1988). 32. See Lettau and Ludvigson (2004). 33. Vuolteenaho (2002) and Cohen, Polk, and Vuolteenaho (2006) find that only a small fraction of individual variation in stock returns around the market return is transitory. 34. See Shefrin and Thaler (1988). Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 271 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 271 272 Brookings Papers on Economic Activity, 1:2007 In the Shefrin and Thaler model, households place wealth into one of three mental accounts: current income, current assets, and future wealth.35 Shefrin and Thaler argue that the propensity to consume wealth categorized as current income, such as dividends, is greater than the propensity to consume wealth categorized as assets, such as capital and its appreciation. Household behavior in their model is thus consistent with the popular advice to “spend from income, not from principal.” Our main results fit well with these predictions. The propensity to with- draw and consume dividends is indeed far higher for dividends than for capital gains. Moreover, in the CEX data, the propensity to consume div- idends is similar to the propensity to consume labor income, consistent with the notion that both are placed in the “current income” mental account. In addition, mental accounting seems to offer more natural explanations for some finer aspects of our results than do the other theories. For example, it is natural that ordinary dividends and small special dividends would be categorized as current income to a greater extent than large special divi- dends, which, in turn, would be seen as still more income-like than cap- ital appreciation. Under mental accounting, one would thus expect a higher propensity to consume ordinary than large special dividends, and a higher propensity to consume the latter than capital gains. Table 9 shows precisely this pattern. The underlying psychology behind this sort of mental accounting is an important open question. Self-control and prospect theory are potential psychological roots.36 Another, anecdotally plausible possibility is that although firm-level stock returns and cross-sectional variation in portfolio performance are largely permanent, individuals do not view them as such. A quasi-rational rule of thumb for a passive investor facing perceived stock market mispricing may then be to consume dividends but not capital gains. Mental accounting of any type suggests bounded rationality, and so a natural way to close this discussion is to comment on the welfare conse- quences of deviating from fully optimizing behavior in this setting. We suspect that these consequences are relatively small for two reasons: divi- dends make up a small fraction of total portfolio returns, and more important, they have a much lower standard deviation. Corporations smooth dividends, 35. See also Shefrin and Statman (1984). 36. See Shefrin and Statman (1984). 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 272 an increase in dividend payouts.39 In fact, they find that a sample of firms with limited tax incentives—the largest shareholder is not taxable—did not increase the rate at which they initiated dividends, for example, and thus they attribute the entire change to tax effects. On the other hand, Alon Brav and coauthors surveyed hundreds of financial executives in the wake of the tax cut and found that they only occasionally cite the tax cut as a motivator of payout decisions.40 Stock market sentiment may also have affected dividend behavior during this period, as some firms initiated or increased dividends in an attempt to distance themselves from the non- dividend-paying “new economy” firms that had crashed in 2000 and 2001.41 In any case, suppose for the sake of argument that the entirety of the observed change in dividends from 2002 to 2003, from $103 billion to $115 billion, was due to the tax cut. Recall that the before-tax MPC rises as the tax rate falls, from 0.4 to 0.48: Applying this estimate to the before-tax increase in dividends, the supply channel adds another $5.8 billion to the effect on consumption, for a total effect of $14.1 billion. At the higher MPC estimate, the total effect is $23.8 billion. Dividends in the Statistics of Income continued to increase in 2004, to $147 billion, including the large Microsoft payout; hence this calculation might still underestimate the effect for subsequent years. Let us suppose the tax cut took two years to have its full effect, and therefore take the rise from the 2002 to the 2004 value as the supply increase. Then the estimates of total consumption effects in the previous paragraph rise to $29.4 billion and $49.9 billion, respectively. To gain some perspective on these estimated changes in consumption, which range from $8.3 billion to $49.9 billion, consider that total personal consumption expenditure in 2003 was $7.7 trillion, and that the average increase in total personal consumption over the previous five years was ( ) , ,11 1 2003 2002 2003MPC MPCpre tax pre tax− −= × − τ 1 2002− τ . 39. See Chetty and Saez (2005) and Poterba (2004). 40. See Brav and others (2007). 41. Baker and Wurgler (2004a, 2004b) study how investor sentiment affects dividend payment. Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 275 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 275 $365 billion, with a standard deviation of $66 billion. Against this standard deviation, effects on the order of those estimated above do not seem trivial. Conclusion How investors consume from dividends versus capital gains is important to a range of questions in corporate finance, macroeconomics, behavioral economics, and tax policy. Classical theories suggest that investor con- sumption patterns are independent of how returns are split into dividends and capital gains, whereas mental accounting and various economic frictions motivate an alternative hypothesis that investors are relatively more likely to consume dividends. The contribution of this study is to exploit the cross- sectional variation in two household-level data sets in order to document the effect of dividends on consumption. The main finding is that consumption indeed responds much more strongly to returns in the form of dividends than to returns in the form of capital gains. Data from the Consumer Expenditure Survey show a strong relationship between household consumption and dividends, after control- ling for total returns (which include dividends). A sample of household portfolio data also shows that dividends are much more likely than capital gains to generate withdrawals from investment accounts, thus illustrating the mechanical process of translating dividend income into consumption. We stress that the interesting result is not that the propensity to consume capital gains is rather low—indeed, it should be low for forward-looking consumers acting according to the permanent income hypothesis—but that the propensity to consume dividends is so high. A review of alternative explanations suggests that the results may in part reflect mental account- ing processes of the sort summed up in the adage, “consume income, not principal.” 276 Brookings Papers on Economic Activity, 1:2007 10657-04a_Baker.qxd 8/15/07 10:14 AM Page 276 277 Comments and Discussion James Poterba: This paper by Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler asks whether the division of corporate earnings between retentions and payouts affects consumer spending. The authors bring novel insight and a creative empirical strategy to bear on a question that has a long pedigree in empirical macroeconomics. Early attempts to model aggregate consumption related consumer spending to disposable income and household wealth. Esti- mates of the marginal propensity to consume out of income were typically an order of magnitude greater than estimates of the marginal propensity to consume out of wealth. Taken at face value, such estimates implied that if a firm reduced its retained earnings by a dollar, thereby reducing its share price, and paid a dollar of dividends, consumer spending would rise by the difference between the marginal propensity to consume out of dispos- able income and the marginal propensity to consume out of wealth. Some researchers argued that, to avoid this stark result, consumption should depend on corporate retained earnings as well as disposable income. This suggestion led to an empirical debate about whether consumers “pierce the corporate veil” and recognize the firm’s underlying earnings, or fail to do this and instead consume at different rates out of different components of corporate earnings. In contemporary textbook models of consumer behavior, current house- hold spending depends on the present discounted value of current and future labor earnings and on current financial assets. In the absence of taxes and other institutional rigidities, a dividend payment, as opposed to a capital gain, should not change a household’s net financial assets and therefore should not affect consumer spending. Yet the possibility remains that different ways of transmitting earnings to shareholders have different effects on consumption. Various models in behavioral economics can 10657-04b_Baker Comments.qxd 8/15/07 10:14 AM Page 277 payout patterns. My table 1 presents information on the concentration of dividend income on individual income tax returns filed in 2004. Just over half of all dividends are received by taxpayers with adjusted gross income of more than $200,000—a group that includes fewer than 8 percent of all taxpayers with dividend income, and about 2 percent of all taxpayers. Data from the Survey of Consumer Finances suggest that households in the top decile of the wealth distribution receive roughly 90 percent of all dividends. In contrast, the highest-income respondent in the CEX has an annual income of just over $300,000, and the mean annual consumption expendi- ture is approximately $60,000. This underscores the absence of households in the top strata of income and wealth. The reason topcoding and the absence of high-income households are concerns is that the behavior of these households may differ from that of lower-income households. Their consumption decisions, in particular, may be less sensitive to cash flow considerations. This possibility suggests the need for caution in using the coefficient estimates in the current study to estimate how broad changes in corporate dividend payouts may affect con- sumer spending. Another concern with the CEX is that the measure of accrued capital gains is very noisy. There are two sources of measurement error in the equity capital gains data. The first is that financial asset values are self- reported. If households do not know the current value of their stock port- folios at the time of the survey, this will translate into noisy data. The 280 Brookings Papers on Economic Activity, 1:2007 Table 1. Distribution of Taxable Dividends by Household Income, 2004 Taxpayers reporting dividends Dividends reported Percent of all Percent of Adjusted gross income taxpayers reporting Billions of all dividends (thousands of dollars) Millions dividends dollars reported < 10 3.55 11.6 5.8 3.9 10–50 9.91 32.3 19.0 13.0 50–100 9.41 30.7 22.6 15.4 100–200 5.41 17.6 23.8 16.2 200–500 1.80 5.9 20.3 13.8 500–1,000 0.38 1.2 11.3 7.7 > 1,000 0.22 0.7 44.1 30.0 All households 30.69 100.0 146.8 100.0 Source: U.S. Treasury Department, Statistics of Income: Individual Income Tax Returns, table 1.4. 10657-04b_Baker Comments.qxd 8/15/07 10:14 AM Page 280 second problem, which may be even more important, is that when house- holds sell stock between two survey dates, there is no record of the timing of the sale. This requires assuming an arbitrary time pattern for such sales, inducing further measurement error. If capital gains are measured with sub- stantial error, while cash dividend income is measured precisely, standard errors-in-variables arguments will lead to an estimate of the marginal pro- pensity to consume from capital gains that is biased toward zero. Such a bias could explain the paper’s empirical results in both the level and dif- ference specifications. The second part of the paper focuses on withdrawals from brokerage accounts. This component of the paper is particularly innovative, and evi- dence on whether investors withdraw dividends from their accounts or re- invest them is of independent interest. The authors note that withdrawals are not the same as consumption, and that message bears emphasis. The CEX- based project uses a measure of consumption as the dependent variable. The brokerage account-based project implicitly assumes that withdrawals are consumed—an assumption that may not be valid for all households. The findings on withdrawal patterns are nevertheless intriguing. The data sug- gest that relatively few investors reinvest dividend payments. This is partic- ularly true for ordinary dividends; large special dividends do appear to be reinvested. A key limitation of this study, and of other studies that have used infor- mation provided by financial institutions, is the restriction to information from a single brokerage firm. If investors hold assets at multiple firms, cross-firm reinvestment decisions will look like withdrawal or consump- tion decisions from the vantage point of a single firm. This is a concern but it may not be a serious empirical limitation. In the 2004 Survey of Consumer Finances, 87 percent of households with a brokerage account have only one. Investors with multiple brokerage accounts are likely to account for a disproportionate share of total dividend income and total stock ownership, but, at least for middle-income households, using data from a single brokerage firm is likely to provide valuable insights. A more subtle concern involves the timing of reinvestment decisions, even decisions with respect to the same brokerage account. An investor who receives a dividend check, deposits it in a money market account or checking account that is not visible to the brokerage firm, and then decides after some time to purchase additional shares of stock will appear to have consumed the dividend if the reinvestment does not happen within the Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 281 10657-04b_Baker Comments.qxd 8/15/07 10:14 AM Page 281 same month as the dividend payment. If dividends are uniformly distrib- uted throughout each month, that leaves on average only two weeks for the investor to make the reinvestment decision before the end-of-month cutoff. The authors recognize this potential problem and note that they can reduce it by widening the time interval over which they measure dividend income and withdrawals. They painstakingly track net account inflows and withdrawals as a function of lagged dividend payments; this offers another way of attacking the measurement interval problem. One concern about the brokerage account data used in this study is whether they are representative of the broader population of U.S. house- holds. Different broker types may attract different types of clients. A dis- count broker, for example, is likely to attract investors who are more inclined to trade than the population at large, whereas a full-service broker may attract clients who view themselves as needing disproportionate levels of advice and assistance in making financial decisions. It is not clear how best to control for any differences between these groups, or between them and investors more generally. The paper concludes with an interesting analysis of how changes in the relative tax burden on dividends and capital gains in 2003 may have affected consumer spending. Three potential effects of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) warrant consideration. First, the tax reform reduced the average tax burden on dividends paid to U.S. investors, thereby increasing the disposable income of these taxpayers. This might increase consumer spending. Second, JGTRRA reduced the tax penalty for paying dividends relative to retained earnings, thereby increasing the incentive for firms to pay dividends. Several studies sug- gest that this led to an increase in dividend payments.2 If the marginal propensity to consume from dividends is greater than that from retention- induced capital gains, this effect would also support higher consumption. In light of the empirical evidence in this study, higher dividend payouts might increase consumer spending. Finally, the tax change may have pro- vided new incentives for investment in the corporate sector. The caution here arises from the temporary nature of the dividend tax cut. A perma- nent cut in the dividend tax would reduce the burden on payouts from new corporate sector investments, making it more attractive for firms to 282 Brookings Papers on Economic Activity, 1:2007 2. See, in particular, Chetty and Saez (2005). 10657-04b_Baker Comments.qxd 8/15/07 10:14 AM Page 282 portfolio choice and consumption has been worked out, the connection between account choice and consumption needs to be clarified. The authors’ second data source is the Consumer Expenditure Survey (CEX). The CEX data are not perfect, but unlike the brokerage account data, they do purport to measure consumer expenditure directly, and the issues of measurement error in these data have been widely recognized and studied. Some of these issues are particularly relevant to the question at hand. One is the topcoding of the data, and a second is that the CEX data do not oversample high-income people, who hold a disproportionate amount of stock held outside of institutions. For these reasons one might worry that any behavioral response of the usable CEX sample is not rep- resentative of aggregate dollar-weighted stock ownership. That the stock- holders in the sample are not high rollers becomes clear when one notes that the median value of dividends and accrued gains in the sample is zero and that the mean annual capital gain is $363 (with a huge dispersion). This will be a problem if, for example, Bill Gates does not keep the same kind of mental accounts as the average stockholder, a plausible notion if there are fixed costs to constructing “better” mental accounts. Perhaps the most troublesome issue in this analysis is the fact that capi- tal gains are probably subject to much greater measurement error than div- idend receipts. This will bias the outcome toward finding that dividends matter for consumption and capital gains do not matter, not only for con- sumption but for anything. Perhaps the Survey of Consumer Finances (or other sources with better capital gains measures) can give a sense of the size of the measurement error problem as well as the induced bias. To be sure of the causal relationships, it would be helpful to have panel data that span a longer period. In their absence one wonders to what extent the authors’ results are driven by heterogeneity—do those people who choose high-dividend stocks also behave differently in managing their accounts? For example, do they also move money in and out of their brokerage accounts more frequently? However, if the observed correla- tions were due to (persistent) heterogeneity of this type, one would expect that lagged dividends would explain such behavior as well as current div- idends, but the authors show that they do not, and that is reassuring, as is the fact that the results survive first-differencing. The tax system is one source of exogenous cross-sectional variation, in part because the federal income tax has graduated rates. If dividends are taxed more heavily than capital gains at the individual level, the income Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 285 10657-04b_Baker Comments.qxd 8/15/07 10:14 AM Page 285 tax system should induce a clientele effect so that, other things equal, highly taxed individuals do not hold high-dividend-paying stocks. One might be initially optimistic that the variation in the marginal tax rate across people provides an instrument with which to examine the effect of dividends on consumption. But, alas, the marginal tax rate is highly correlated with income, and so it would be difficult to separate the effect of receiving div- idends from the effect of income itself. Note, however, that although highly taxed individuals normally would be unhappy about higher dividends, they also would benefit most from a temporary cut in the dividend tax, which may be part of what the 2003 tax change, discussed below, was perceived by many to be. The authors want to make assertions about the aggregate consumption impact of dividend changes. To make such statements with the data they have, one would need to know why dividends, or after-tax dividends, change over time for different shareholders. It could be that higher dividends are a signal of improved company prospects, in which case there would be both a dividend effect and a wealth effect. If instead changes in dividends reflect a changed payout policy, then higher dividends would imply lower expected capital gains, with no first-order wealth effect. What if a change in dividends results from a tax policy change, one that either changes the incentive to pay out a given amount of after-tax earnings, or changes the amount of after-tax earnings itself, or both? The tax issues are tricky and are controversial among public finance econo- mists, with the varying theories loosely classified as either “new view” or “old view.” What is distinctive about the new view is that it implies that a permanent dividend tax cut will not change the payout behavior of mature firms (those whose earnings exceed good investment opportuni- ties). In this case the dividend tax cut represents a windfall gain to share- holders (and, presumably, a windfall loss to other taxpayers). In general, the fact that a dividend tax cut should have different effects on different companies may help to identify the effect of a tax change, the payout re- sponses to it, and shareholders’ responses to both. To the extent that a divi- dend tax cut is perceived as temporary, this is a good time to get money out of a corporation. The paper gives little attention to the authors’ preferred explanation of their findings, namely, mental accounts. The behavior the authors identify does seem to follow the maxim about consuming income but not principal. But is it a rule of thumb that economizes on cognitive capital and trans- 286 Brookings Papers on Economic Activity, 1:2007 10657-04b_Baker Comments.qxd 8/15/07 10:14 AM Page 286 action costs, one that works well in most situations but may work poorly in unusual circumstances? Is the goal also to smooth saving, rather than consumption, so that unexpected income can be spent but spending can be cut back in bad times? Individuals’ reliance on mental accounting is certainly heterogeneous. Who, then, is likely to use it—does it relate to one’s sophistication in dealing with financial issues? Does it relate to wealth, as seems plausible if there are fixed costs to be saved by using simple rules of thumb? What might cause users of mental accounting to abandon their rule of thumb? One possibility is special dividends. Another is windows of time created by temporary, or possibly temporary, tax changes. Prominent news stories about corporations reacting to a tax change might be noticed by some tax- payers, who react by altering their usual mental accounting. Once we are in the realm of behavioral economics, how far do we need to expand it? One might, for example, also consider the cognitive process of corporate officers. Surveys suggest they do not act as if they solve either the new view or the old view problem, but themselves use rules of thumb as well.1 How shareholders react to dividends induced by tax changes also overlaps with the nascent field of behavioral public finance.2 Note that the response of cognitively constrained individual shareholders to corporate behavior is in some ways similar to the response to government behavior: both corporate and government policies may move taxpayer “money” from one pocket, or mental account, to another. This raises a large set of inter- esting questions, including whether people have particular cognitive issues with respect to tax cuts. Do taxpayers have the cognitive sophistication to be Ricardian, or is this a particularly difficult cognitive problem whose so- lution involves rules of thumb and mental accounts? These issues arise in trying to understand taxpayer responses to anticipated tax refunds or occa- sional tax “rebates.” The paper ends by relating the authors’ research program to the U.S. experience in 2003, when the tax on dividends was cut substantially. I would like to see the authors clarify the prediction of mental accounting with respect to exogenous changes in payouts. Do their findings imply that a permanently increased dividend payout ratio would induce share- holders to consume more forever? This seems implausible and would Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler 287 1. Brav and others (2007). 2. 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