Wall Street Meltdown: 2003 taxcuts are to be blamed?

Investment Banks knew that it was coming in 2008. How? Look at the systematic increase in the "Dividends Paid", in last few years, by the banks which failed/got bought out: Bear Stearns, Lehman Brothers, Merrill Lynch etc. Their financial statements tell the story. What does that really mean? Well, this is what economists call a classic Principal-Agent problem. As part of 2003 tax-cuts, one of the important change was, reduction in the tax rates on both dividends and capital gains. That gave incentives to all the CEOs to find means and ways to increase dividend payments. Dividend payments, of course, are dependent on revenues generated, meaning, to increase dividend payments revenue needs to be increased( Afterall, you should be able to justify, if you plan to play your game for few years). This is a triple whammy, on one side you need to increase the revenue so you can justify increased dividends, on the other side, less capital is available for next year because of cash being paid as dividends which could have been otherwise invested to generate more revenue in future. Apart from that, since you have less capital available to invest, you will take more debt to fund future investments.

As more and more dividends were paid, people looked for more and more ways to generate even higher revenues, of course, taking more and more debt along the way. With-in a few years, what you have is a huge number of companies on Wall Street with high debts and lower valuations. Question can be, why some companies failed earlier than others? Well, it really depends upon how fast they increased the size of debt in their pie of capital structure. Mortgage crisis was partially the result of this game, and ultimately helped in expediting the fallout. Why investment banks first? Because they can really take much-much more debt than other companies, so its not a surprise that the phenomena started with investment banks. Are there other sectors involved? I believe the answer is a big YES! Isn't that supported by the big figure of $700 billion? Well, they are trying to stagger it so that it doesn't look as bad, otherwise it is $1 trillion. Now the biggest question, why 2008? Well, think! the compromise to reduce the tax on dividends and capital gains to 15% is set to expire in 2008. Again, why 2008? Well, that is left to your imagination. For the time being, the world has a huge mess to deal with.

References:

Preliminary proof of this phenomena:
http://elsa.berkeley.edu/~saez/chetty-saezAEA06.pdf

Economists were concerned about it:
http://www.heritage.org/research/taxes/wm594.cfm



Disclaimer: I really dont know if this is the true reason. I would not have been sitting here writing this blog, if that would have been the case. So, use your own judgement! :-)