The InvestMentor

January 15, 2003

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This week, I’ve taken the opportunity to analyze President Bush’s economic proposal with its unexpected elimination of taxes on corporate dividends as the centerpiece.

(Truth be told, I didn’t read the entire proposal. I don’t have a copy of it, and even if I did, to read it would be a form of cerebral self-mutilation up there with watching slide shows of someone else’s vacation and studying transcripts from old episodes of C-SPAN).

The main concepts of the plan are simple to understand.  My take is that it won’t provide much true “stimulus” to the current economy, that it does favor the rich, and it really doesn’t do that much for dividend paying companies. However, it’s good policy and won’t raise interest rates as some suggest.

Stimulation is Back-Ended

Unlike Monetary policy, Fiscal policy isn’t stimulative in the short-run. But who cares? We’re out of the recession, sluggish as it may seem. We’ve had five quarters in a row of growth in GDP. That’s a good thing because even if the policies were in place today (which they aren’t) and if they weren’t watered down by Congress (which they will be), the lag effect would put the benefits off several quarters, and they’d only be measurable on the margin down the road.

Stickin’ it to the Rich

The bulk of the benefits accrue to the rich. That should be obvious, and in this case, encouraged. The top two quintiles of tax payers foot 85% of the country’s tax bill. By reducing the Government’s share of an investor’s return on capital, the system has more capital left for reinvestment—which is really what the rich do with incremental wealth, as opposed to consume it. There’s a time and a place to tilt policy towards the lower quintiles—like consumption-led recessions—but it’s just not what’s ailing our system right now.

Interest Rates, Schminterest Rates

One of the arguments against eliminating the tax on dividends is that it will cause interest rates to rise. Not true—if it was, we’d have seen a Matterhorn-like slope to the yield curve since the plan was made public, and that hasn’t happened (for a cool, dynamic yield curve chart, check out stockcharts.com).

Opponents argue that with dividends tax-free, people who would buy bonds, namely muni bonds, might opt against them in favor of dividend-paying stocks, forcing issuers to offer higher rates on their bonds. Those who buy a lot of stocks and bonds for a lot of people know that stocks and muni bonds aren’t really in the same opportunity set. Even tax-free, dividend yields are still below muni yields, and stocks carry risks that fixed-income investors won’t handle well.

Hoard Dividend Paying Stocks? Nah.

The greatest misunderstanding about the proposal is that it will be great for dividend paying stocks. It will be good for stocks overall, because as I mentioned it leaves more money to be reinvested, but it won’t really do much to elevate the attractiveness of dividend paying stocks.

Use Alcoa (AA) as an example. The stock is worth is $22.20. The dividend is 60 cents per share. That’s a pre-tax yield of 2.7%. Currently, a holder of Alcoa would actually only have about a 1.8% true dividend yield, if 20 of the 60 cents goes to taxes. But if the tax is eliminated, their true yield becomes 2.7%. But that’s only a difference of 90 basis points, or 20 cents per share. Hardly worth loading up the portfolio with Alcoa.

The Visceral Reality

Fundamentally, the corporate dividend double-taxation is one of a few glaring overly-burdensome rules in the tax code that are way overdue for overhaul (along with the marriage penalty and [some would say] the death tax). Fixing it is something few disagree with. However, support versus opposition for the plan falls predictably and neatly along partisan lines.

But this plan, while not doing much for the recovery, will be good for capital formation and investment, and will pay its own metaphorical “dividends” far into the future.