Dividend-Paying Stocks Have Cloudy Future

Congress passed the $350 billion economic package Friday, which among other things, reduces dividend taxes to 15%. The maximum rate currently paid on dividends is 38.6%. Investors in the 15% and 10% income tax brackets will pay just 5% tax on their dividends through 2007, and in the last year of the bill they won't have to pay any taxes on dividends.

While some argue that the bill provides an incentive for investors to move into high-yielding stocks, others aren't so sure, noting that the plan also allows for a reduction in long-term capital gains taxes. Most investors currently have to pay a 20% tax on any profits they make after selling a stock that they have owned for more than a year. But the new bill says investors should only have to pay a 15% tax on these gains. This provision actually encourages investors to focus on a stock's capital appreciation, not just its yield, so it's unlikely that there will be any major shift in investor behavior, and speculation could continue to thrive.

Joe Lisanti, editor in chief of The Outlook Newsletter from Standard & Poor's, said the dividend tax cut might not do much to change corporate behavior either.

"You may see a few companies divert some of money to paying dividends, but that does not necessarily mean that all of them are going to increase their payout ratios enormously," he said. "It's still to the benefit of corporate managers and directors to buy back shares, boost the per-share earnings and drive the stock price up, because they benefit from options or restricted stock or other mechanisms tied to the stock. They still have an incentive that is not necessarily the same as the shareholders."

Still, Lisanti said he believes the dividend tax break is more important in some ways than the capital gains tax cut, which he said is only "theoretical" because the benefits aren't seen unless the investor sells the stock and realizes a gain.