The Dividend-Tax Cut

December 7, 2002


Early next year, the Bush Administration is expected to push for a dividend-tax cut as part of a major effort to cut taxes and give the economy and the stock market a boost. As with any tax law change, the pro and con advocates are drawing their lines in the sand and making their cases.

Dividends are exposed to double taxation. First, corporations pay dividends from net after-tax earnings. When an investor receives the dividend, the investor is taxed on those dividends received at his/her ordinary income tax rate.

During the last decade, many of our largest corporations have moved away from paying dividends, preferring instead to reinvest earnings in their enterprises, adding shareholder value in the form of capital growth. As their business increased, so did their stock prices. Investors could capitalize on this growth by selling the stock and paying capital gains tax on the increased value. Since capital gains are taxed at a lower rate than dividends, this strategy gave investors the greatest after-tax return.

That was before the Crash of 2000-02. With capital gains as scarce as hens’ teeth, and stock prices down, what were once miniscule dividends are now generating attractive yield figures. Some of the Dow stocks are now sporting dividend yields greater than the yield of a ten-year Treasury. It’s not surprising that there is interest in cutting the taxes on dividends!

Proponents maintain that cutting taxes on dividends would make dividend-paying stocks more attractive to investors. They also say dividend-tax reductions would spur business investment and encourage corporations to finance growth by issuing stock rather than the more destabilizing method of borrowing money. However, corporate CFOs find borrowing to be more tax-efficient because interest paid is a tax-deductible business expense.

The White House is quick to point out that by eliminating the tax, it expects government revenues to increase as a result of increased business activity in the economy. However, all of its members are not together on this point. Treasury Secretary Paul O’Neill is one outspoken exception, arguing that we do not need the tax cut. His opposition may have something to do with his resignation, announced last Friday.

Opponents of this tax cut make the point, as one might expect, that this is another case where a benefit goes only to the "rich" and is of little benefit to the masses. Since more than half of all U.S. households own stocks in one form or another, this leaves the definition of "the masses" somewhat in doubt.

A more relevant argument against this tax cut is that it may lead to entirely unintended consequences. During the 1990s, corporations used their capital to reinvest in and grow their businesses. This expansion of capacity and productivity fueled one of the greatest Bull Markets for stocks in history. Without this reinvestment of capital, one has to wonder if the remarkable expansion and increased productivity would have been so remarkable.

If stock prices become linked to dividend payouts, corporate America could find itself with more incentive to distribute cash as dividends rather than to reinvest, for long-term health and growth, in their enterprises. Imagine corporations giving executives stock-paying tax-free dividends instead of options with potential ordinary income taxation consequences.

Finally, since more than half of all dividend-paying stocks, according to a recent article in the Wall Street Journal, are held by non-tax-paying entities such as pension and IRA accounts, does all of this really matter? The jury is still out.


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