FROM THE OFFICE OF PUBLIC AFFAIRS

October 29, 2004
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Remarks of Mark J. Warshawsky
Assistant Secretary for Economic Policy
The Role of Tax and Regulatory Policies in Improving Good Corporate Governance
Detroit Economic Club

It is a pleasure to speak to you this morning about the role of tax and regulatory policies in improving corporate governance and in particular the linkage between effective policies and strengthening confidence in our market institutions.

The revelations of corporate scandals in 2001 and 2002 negatively affected market and investor confidence, creating a "confidence deficit" one might say. Fortunately, positive and complementary developments occurred in the areas of financial regulatory policy and tax policy that offset these negative factors and have contributed, I believe, to a sense of confidence and stability. The 2003 tax law enhanced corporate governance by creating incentives to payout a higher fraction of the "free" cash flows in excess of profitable investment opportunities to shareholders, reducing the extent of management's discretionary control over financial resources. This should have a salutary effect on confidence by bringing manager and shareholder interests into better alignment. Sarbanes-Oxley improved the quality of financial reporting and changed investor expectations of auditor and corporate behavior, further reducing the confidence deficit.

Before I delve into this, let me briefly talk about the macroeconomic context in which these policies were implemented. When President Bush took office in January 2001, he inherited an economy that had already weakened significantly. In spring of 2000, equity values dropped sharply, by mid-year industrial production had begun to decline and business fixed investment had stalled, contributing to negative GDP growth in the third quarter of that year. In March 2001, the economy sank into recession. The business cycle that began when the economy officially reached a peak that month has been unique for many reasons. Not only was it exacerbated most notably by the terrorist attacks of September 11, but the economic and financial recovery was delayed as the full dimension of corporate scandals dating back to the 1990s became apparent in 2001 and 2002. For example, in fourth quarter 2001, just at the November trough of the business cycle, real GDP grew at a 1.6 percent seasonally adjusted annual rate; a year later, real GDP grew at a mere 0.7 percent annual rate. The confidence deficit was also reflected in the stock market – one of the important leading variables for an economic recovery. Early signs of modest recovery in the stock market just prior to the official November 2001 recession trough quickly dissipated. In the year following the trough of the cycle, the S&P 500 index declined by 17 percent. This is especially striking when we consider that, in the third quarter of 2002, operating earnings for the S&P 500 were nearly 27 percent higher than they had been a year earlier; plainly, a lack of confidence kept the stock market from responding to improved economic performance.

The Jobs and Growth Tax Relief and Reconciliation Act (JGTRRA) of 2003 was a turning point. Along with an expansionary monetary policy, the passage of JGTRRA played a significant role in getting the economy onto a better and quicker growth path. As you know, the President proposed his tax cut plan in January of 2003; it was passed in May and made retroactive to the beginning of the year. The economy responded almost immediately. Job growth resumed in September 2003 and over the 13 months through September of this year American businesses added 1.9 million workers to their payrolls. The unemployment rate has receded from a peak of 6.3 percent in June 2003 to 5.4 percent in September of this year, lower than averaged in each of the past three decades.

Thanks to the President's various tax relief measures, American families have more money to spend. Real after-tax income has risen by 10 percent since December 2000, exceeding the performance recorded after the last recession and helping support personal consumption expenditures.

The current low-inflation, low-interest rate environment has also been very supportive, with the latter playing a pivotal role in the exceptional performance of the housing market. The homeownership rate is at a record 69 percent so far this year, and housing starts and home sales are on track to top last year's remarkable performance. The residential sector dampened the impact of the recession and has been a key factor in fueling the recovery.

These are but a few examples of the positive outcomes generated by recent fiscal and monetary stimulus. The bottom line is that U.S. economy is strong and getting stronger. Real GDP rose at a solid 3.3 percent annual rate in the second quarter following an impressive 5 percent gain over the prior four quarters – the largest such increase in nearly twenty years. The Commerce Department announced this morning that real growth increased to a 3.7 percent annual rate in the third quarter.

What you might not recognize, however - and which is of particular importance for my remarks today - is that the Jobs and Growth Act led to a significant increase in regular dividend payouts, the number of companies initiating dividends, and a decreasing reliance on debt financing. All of these things are positive from the point of view of good corporate financial health, corporate governance and confidence in market mechanisms. These effects perhaps are not as obvious as changes in the more familiar macroeconomic indicators, but they are quite important. Let me discuss this in more detail.

Among its provisions, the Jobs and Growth Act reduced dividend tax rates to 15 percent in most tax brackets; and dividend and capital gains tax rates were brought into equality at 15 percent. Taxpayers in the lowest two brackets now pay 5 percent on dividend income.

The reduction of the double taxation of dividends contained in JGTRRA directly addresses a critical corporate governance issue, called the agency problem. "Agency problem" means that corporate managers make decisions in their own interests rather than interests of shareholders. The problem is facilitated when a cohesive group of managers knows more about the operations of the company than a widely dispersed set of shareholders. Without a low-cost institutionalized structure to channel critical information to shareholders, it is difficult to achieve a concerted and informed exercise of shareholder rights over managerial decision making. The tax reduction lowered the cost to shareholders of implementing strategies that reduce agency problems by increasing the after-tax share of each dollar of dividend income. Because dividends were previously taxed at a higher rate than capital gains, corporations were encouraged to retain, rather than distribute, earnings. Investments made with retained earnings are usually subject to less scrutiny than those financed with outside equity or debt, reducing the pressure on corporate managers to undertake the most productive investments. Thus, dividends increase corporate accountability vis-à-vis investors. And critically, when managers are required to go to the capital markets to finance investments or acquisitions they become subject to the objective discipline of the markets' assessment.

In a seminal paper, Michael Jensen described how agency problems can be particularly significant for certain types of companies, with deleterious consequences. For example, if a relatively stable company has substantial cash flow but few profitable investment opportunities, managers may have incentives to encourage unjustified growth as a means to achieve higher compensation or promotional opportunities. In these circumstances we would expect to see capital expenditures made in low-return projects, or diversification outside the core business expertise. Research indeed indicates that poor corporate governance provisions that entrench management interests and weaken shareholder rights is associated with suboptimal stock returns, lower profits and sales growth.

So, dividend policy is an effective mechanism to control unproductive managerial discretion. And while dividend payments technically are subject to more flexible adjustment than interest payments on debt, the fact is that it is rare for dividend increases to be reversed except for compelling reasons.

A financial policy that commits the firm to both fixed interest and dividend payments places strong limits on management discretion. It also sends an important signal to investors about the quality of the firm's operations and business strategy, that is, the company's ability to generate cash flow.

We also have evidence that the new tax law indeed had a significant effect on dividend policy. A compelling study appearing in an NBER working paper quantifies the linkage between significant increases in dividend payouts to the tax law changes. It is striking that statistically significant changes in behavior are detected both for companies initiating new dividends and for companies raising dividend amounts that were already in place.

The NBER study covers the period first-quarter 1980 to first-quarter 2004, and includes approximately 3,800 companies trading on the NYSE, AMEX and NASDAQ. Since the distribution of aggregate dividend amounts is highly concentrated, and affected by a few major entities, the authors focused on the number of firms initiating new dividends, and found that the trend in new dividend payments turned positive in 2003, after falling for more than two decades. The study also found a significant increase in the probability that a company already paying dividends would raise its regular quarterly payment by more than 20 percent; this finding was broad, across companies of all types, after controlling for company profitability and other characteristics. There was also a significant increase in special one-time dividends. Thus, the evidence strongly supports the view that higher dividend payouts were in response to the tax law changes; this should rein in managerial discretion and reduce agency problems.

A review by our office of annual S&P 500 company data from 1988 to 2003 corroborates the detailed NBER findings, with increases in both the number of new initiations and number of higher regular dividend payments, as compared to recent history. There are a number of other studies that reach the same conclusions.

I would next like to briefly review the second important contributor to building investor confidence, corporate accountability legislation. The Sarbanes-Oxley Act in essence declared that the quality of financial reporting should be raised, by making it more transparent, consistent and accountable. By doing so, market confidence would be bolstered because expectations of auditor and corporate behavior were changed.

We do not have time to review all ten titles of the legislation, but among the Act's key provisions was the creation of the Public Company Accounting Oversight Board (PCAOB). Indeed, last year, the PCAOB completed interim inspections of the "Big 4" accounting firms. Title II addresses concerns that auditor independence may be compromised by large fees for non-audit services by prohibiting an accounting firm from providing certain non-audit services contemporaneously with the audit. And under Title IV, both management and the accounting firm are responsible for assessing the effectiveness of a company's internal controls in deterring fraud, with severe penalties for noncompliance.

Confidence in markets should be enhanced because the law increased the quality of financial reporting and changed expectations about the behavior of both auditors and their clients. Have expectations been realized? One source of evidence on auditor behavior is the frequency of earnings restatement announcements; if the auditor has been doing its job properly we would expect to see the frequency decline. Unfortunately, this is a much widely used and abused metric: restatement announcements generally refer to financial statements that are a few years old, so we must wait at least another year or so before the restatement data truly reflects any impact of the law.

Another measure of auditor behavior is the propensity to issue adverse opinions when circumstances warrant – in other words, is the auditor giving its client a free pass or not? We have taken an initial look at the tendency of auditors to issue "going concern modified opinion reports" to financially weak companies before and after the law changed. We found that there was an increased likelihood that an adverse opinion would be issued after the law was passed, controlling for company financial characteristics. These results are consistent with previously published research that examined the effects of earlier changes in the legal environment on auditor behavior. I must stress that these are preliminary findings; there may be other as yet unidentified factors contributing to this "shift effect" and we have to see if the results generalize to samples of financially healthier companies. So far, though, the initial results are consistent with our expectations.

Turning to some direct, but admittedly soft, evidence on the impact on corporate behavior, I would like to review some highlights from a worldwide survey of over 300 executives conducted last year by the Economist Intelligence Unit that elicited views on corporate governance. The Economist Intelligence Unit is part of the same organizational structure that houses The Economist magazine; it provides business information and analysis of political and economic environments to multinational companies.

It is noteworthy that over 40 percent of the survey respondents feel that vested management interest is the single most important barrier to good corporate governance; this is precisely the source of agency problems that is addressed by the tax law changes encouraging dividend payouts.

It is both interesting and extremely encouraging that 70 percent of these international executives thought that the U.S. had done most to improve corporate governance. The results are especially impressive when compared to some of our friends overseas. For example, 16 percent thought the U.K. had made the greatest strides, while just 3 percent thought so for France.

Companies have taken a number of steps to change their governance practices: For example, 55 percent of the firms in the survey have strengthened the internal audit function, while almost half (49 percent) have improved risk management. Positive results are flowing from these changes, including a better grasp of business issues at the senior management level. From the perspective of mitigating agency problems created by vested management interests, it is most significant that 75 percent of the executives in the survey observe an increased activism among shareholders and an insistent demand for relevant information.

In summary, the U.S. economic system incurred a confidence deficit as a result of: recession, terrorism and corporate scandals. We have come back. The President's tax package helps re-direct cash flow to shareholders through increased dividends, thereby reducing agency problems and wasteful managerial decisions. Sarbanes-Oxley increased the quality of financial reporting, and changed expectations of auditor and corporate behavior. Tax and regulatory policy have joined together to promote corporate governance and efficient use of resources, significantly reducing the confidence deficit.

What can we expect from this point forward? These benefits should continue, assuming that the tax law changes remain intact. Hopeful indications are to be found in Jensen's theory of agency problems and economic research that links corporate governance to performance. The tax law changes have sharpened and clarified the differences between two paradigms: companies that signal they are addressing agency problems through their financial policies and governance procedures, and those that do not. I think we can be reasonably confident that market valuations will inevitably reflect these relative differences, helping to loosen even the most entrenched management enclaves.

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