Don't Expect a Flurry of New Dividends

Here's one more reason President Bush's plan to eliminate taxes on dividend payouts likely won't help the economy: Thanks to the more complicated underbelly of the proposal, corporations will not be any more likely to pay dividends.

That underbelly is essentially a back-door capital-gains tax cut, which -- by design -- will probably preclude companies from feeling pressured to issue dividends. "With this proposal, the decision by a corporation whether to retain earning or distribute them ... would be more neutral," according to the Treasury Department.

As chief executives will be the first to tell you, companies can't pass on all of their profits to investors. Corporations need to retain at least some earnings to grow and maintain the business -- whether through purchasing new equipment, new land or new businesses.

The administration's proposal would permit corporations to adjust for those reinvested earnings in a way that increases shareholders' stock basis. (Your basis in a stock is whatever money you've invested -- be it through your initial or subsequent purchases, or through reinvested dividends.)

Basically, for every $1 per share of already-taxed earnings the company reinvests, investors will be able to add $1 to their basis -- a so-called "deemed dividend." By increasing the investor's basis, the adjustment will (by definition) lower the gain when the stock is sold. And less gain means less tax.

In other words, companies can still keep their profits and investors will still get a tax break.

"The plan wouldn't work well at all without this aspect," says Tom Oschenschlager, a tax partner at CPA firm Grant Thornton. "Otherwise, it would increase pressure on companies to distribute all their profit as dividends. It would virtually encourage them to nearly liquidate."

But because the "deemed dividend" tax break won't be realized until investors sell their shares, it's likely to have zero near-term effect on the economy -- ostensibly the goal of Bush's plan.