Topping Wall Street's wish list for President Bush's economic stimulus proposal is the elimination of the so-called double taxation on dividends.
Since Charles Schwab raised the issue of dividend-tax relief at the president's economic forum in Waco, Texas, last summer, supporters (including our own Jim Cramer) argued such a change would help drive the economy and provide a big boost for the stock market.
Conservative pundit William Safire recently opined in
The New York Times
that ending the taxation on dividends also would help cure corporate wrongdoing, as it would "devolve more power to stockholders."
But as is often the case on Wall Street, it pays to examine whether the reality will match the rhetoric. In this case, it isn't likely.
"We don't know what any proposal looks like,
but if it's just a cut in the marginal tax rate, I don't know if it does a heck of a lot, especially for mutual fund investors, because fees already eat up most of the
dividend yield," said Joel Dickson, tax specialist at Vanguard Group.
Under current rules, dividends paid by corporations come from profits and are taxed at the corporate rate. Meanwhile, individuals pay taxes on dividends they received at the regular income tax rate. The current scuttlebutt is that the Bush administration will propose an exemption for individuals -- anywhere between the first $5,000 to $50,000 of dividends will be tax-free.
Such a proposal "would have a positive effect on those companies who have above-average dividend yield, and it raises the after-tax returns on stocks, period," said John Rock, manager of the $95 million
Enterprise Equity Income Fund . "Companies yielding between 3% and 5% would benefit initially the most, and people would look at those as competition for municipal bonds." (As an aside, some believe such changes would dampen demand for closed-end municipal bond funds, which offer attractive tax-free yields but lack the potential upside presumably offered by equities.)
Companies that have either maintained a steady dividend over a long period, such as
, or that regularly increase their payouts, such as
, will be the initial beneficiaries of dividend tax-law changes, Rock said. His fund is currently long GE and contemplating a purchase of Kodak.
Few argue with such analysis, but even some ardent supporters of dividend-tax reform believe the broader market impact will be modest, as will changes to investor and corporate behavior.
A reduction or elimination of the taxes individuals pay on dividends "will probably benefit those companies that already pay dividends," agreed Richard Bernstein, chief U.S. strategist at Merrill Lynch. But "the removal of double-taxation could have a smaller, or more drawn-out, impact on equity valuations than is generally expected."
Tax Change Won't Slay the Bear
In a report this week, Bernstein argued that companies will be slow to alter their dividend policies, suggesting it will take "quarters and years" for nondividend-paying companies to change.
"Corporations may have used the double taxation of dividends as an excuse to maintain control of their cash flow," he mused, expressing doubts tax-law reform would rapidly alter such behaviors and attitudes. Furthermore, paying dividends is anathema for many firms, especially in technology.
Recent comments by
CFO John Connors speak to this point. At the firm's annual meeting last month, Connors disappointed some shareholders by saying the software giant will not use its some $40 billion in cash to pay a dividend until its legal woes are resolved. Concern about litigation is understandable, but it's unclear if Microsoft will ever be totally clear of such risks, or whether it's using the threat of additional lawsuits as a rationale for not paying dividends.
"You can't expect, and I don't think anything that changes dividend taxes or eliminates the double taxation would increase Microsoft's propensity" to pay a dividend, said James Claus, research officer in the active equities group at Barclays Global Investors, which manages over $80 billion. "The same is true for a lot of growth companies. They believe they have options to invest with greater growth
potential than what average investors could invest in."
Claus stressed that's a perception among tech executives and he believes "management is too optimistic." But the antidividend culture persists in Silicon Valley, as was recently displayed when shareholders of
voted nearly 10 to 1 against a proposal for the firm to use some of its $21 billion in cash to pay a quarterly dividend.
Paying dividends is viewed by many firms as a tacit acknowledgement that their investment options and/or industry growth potential is limited, James Cusser, a portfolio manager at Waddell & Reed, recently told
Beverly Goodman, who
examined the issue last month. "It's a game of perception."
(On the flip side, recent history of firms such as
indicate companies will be very reluctant to cut existing dividends, even in the face of difficult economic realities.)
Merrill's Bernstein reviewed several other perceptions about dividend-tax reform, including:
Many presume any bill passed will take effect immediately, i.e., early in 2003, or may even be retroactive. But Bernstein argued the effective date might be pushed into 2004 because of the budget deficit, and "doubt s that the financial markets will react well if this issue of timing and the budget deficit is not even discussed, as it might ignite a broader fear of fiscal irresponsibility."
The notion corporations can simultaneously increase dividend payouts and investment spending, a crucial element of the economy's health going forward, is highly dubious, Bernstein wrote.
Finally, and perhaps most important, he disputed the presumption that eliminating double taxation of dividends will "quickly and substantially" raise equity returns.
Currently, only 39% of all publicly traded U.S. corporations pay dividends, Bernstein observed. While 71% of
components make dividend payments, that's down from 87% in 1982. Assuming no taxation of dividends, the dividend yield of the S&P 500 would be 1.74% vs. the current rate of 1.13%, assuming a 35% tax rate, he continued, doubting 60 basis points of additional yield is sufficient to materially change investor behavior.
"Investors remain very capital-appreciation oriented," Bernstein wrote, noting they continue to pay premium valuations for high beta/low yielding stocks, namely tech shares. "Investors are more worried about missing the turn in the market and missing out on capital appreciation than they are about capital preservation."
In sum, the strategist favors eliminating the double taxation on dividends and believes it will boost his "yield-oriented" strategy. However, the idea that companies and/or investors will significantly change their behavior because of dividend-tax policy revisions "might be misguided," he concluded, something all those with a (literal) vested interest in the debate need to at least contemplate.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.