Dividends: Can a Tax Cut Crank Up the Economy?

The White House prefers a plan to exclude 50% of dividend income from taxes over one that slices the tax rate

When President Bush unveils his new "jobs and growth" package in January, a key element will be tax relief for investors in dividend-paying stocks. Proponents believe easing the tax bite on investors' dividend income would spark the stock market--and put more jingle in consumers' pockets. That cash, they argue, could keep the expansion from flagging.

Advocates also think encouraging companies to put more of their profits into dividends could prevent a replay of the speculative excesses of the Go-Go Nineties. "Managers with excess cash let the money burn a hole in their pocket," says Henry J. Herrmann, chief investment officer of Overland Park (Kan.)-based Waddell & Reed Financial Inc. "Paying dividends would inject a little discipline into Corporate America."

Critics, however, aren't sold. For starters, they say the idea's stimulative effect is overstated, since the mostly well-to-do beneficiaries of the tax cut have a low propensity to spend any extra dollars the government passes on to them. Further, skeptics contend that pushing companies to pay larger dividends might actually reduce the resources available for new capital spending. Here's a look at the issues surrounding the controversial proposal:

Q: What will the Administration propose?

A: The White House is mulling several measures, one that lets investors exclude a percentage, probably 50% of any dividend income from taxes, and another that simply taxes dividends at the same 20% rate as capital gains. Some in the Administration prefer the first route, since it gives the President the option of raising the exclusion in later years until the tax on dividends is completely phased out.

Q: What are they hoping to achieve by trimming taxes on dividends?

A: The President is expected to assert that cutting the dividend tax will be a tonic for the stock market. At the same time, the Administration sees easing the tax as a first step toward tax reform. The White House wants to move toward a system that taxes consumption more than investment. Bush's advisers believe that reducing taxes on dividends would end the current distortion in the tax code that effectively encourages companies to load up on debt, since interest is deductible but dividend payments aren't. Cutting dividend levies would also permit GOP leaders to give breaks to upper-tier taxpayers in a way that's less conspicuous than, say, moving up another scheduled reduction in the top marginal rate. Democrats are poised to attack the latter course as a giveaway to the rich.

Q: What are the odds Congress approves the plan?

A: Pretty good, but it won't pass without a fight. Democrats will argue that an across-the-board exclusion overwhelmingly benefits the wealthy. For example, most of the benefit of a 50% dividend exclusion would go to the richest 1% of taxpayers. And there are budget issues as well: A 50% exclusion would cost more than $100 billion over 10 years.

Q: Does business support cutting taxes on dividends?

A: Yes and no. National Association of Manufacturers President Jerry J. Jasinowski believes easing the tax on dividends would help "keep consumption strong and shore up [investor and business] confidence." But since the tax break is being structured to benefit individuals, rather than companies that pay dividends, many corporate reps would rather see alternative forms of stimulus that benefit them more. Some may quietly urge the White House to scale back the size of the dividend plan in favor of providing companies with tax breaks for new purchases of capital equipment.

Q: So why not just eliminate the taxes companies pay on dividends, rather than giving the break to individuals?

A: Giving companies a tax deduction on the profits they pay out in dividends would provide faster, more direct aid to companies, since it would immediately boost cash flow. That could allow CEOs to make new capital investments right away. But investors now pay tax on only about 50% of dividends. Pensions and foreign investors avoid all tax now on investment income. Thus, a corporate deduction for dividends would leave half of all payouts completely untaxed. And such an arrangement raises political problems as well, since companies don't vote, investors do. And in light of the recent spate of corporate scandals, the Bushies fear too many business tax breaks would be seen as handouts to Corporate America.

Q: Would easing the dividend tax really boost the economy?

A: Not in the near term. Investors won't be in a position to take advantage of the new break until they start preparing their '03 tax returns in April, 2004. The White House surely hopes that the economy will be back on track by then. And since roughly half of all dividends are paid to investment accounts that aren't taxed, such as 401(k) retirement funds and pension funds, even then many shareholders wouldn't reap much benefit.

Q: What about the impact on the stock market?

A: As a Columbia University economist in the 1990s, White House economic adviser R. Glenn Hubbard estimated that a full repeal could lift stock valuations by as much as 20%. Few market mavens believe the effect would be anywhere near that now. But Lynn Reaser, chief economist for Banc of America Capital Management, predicts that repeal of the individual tax on dividends could bring a 6%-to-9% rise in the market, since it would raise aftertax yields. And Steven Galbraith, chief investment strategist for Morgan Stanley, believes the move would boost stocks that already have the highest returns, including utilities and the regional Bell phone companies.

Q: That assumes the change would motivate investors to suddenly buy dividend-paying stocks. Will it?

A: Early signs are encouraging. Sam Stovall, chief investment officer at Standard & Poor's (like BusinessWeek, a subsidiary of The McGraw-Hill Companies), believes there has already been a shift toward safer dividend-paying shares. He notes that while the S&P 500-stock index was down 18.4% through November, the 350 dividend-paying stocks listed were down less than 9%. But dividend stocks haven't moved much in the month since the Administration floated the plan, a sign that investors either are dubious it will pass--or simply aren't clamoring for any more dividend stocks.

Q: So will more corporations shift toward paying dividends?

A: Some will. At Cisco Systems Inc. (CSCO ), which has a cash hoard of about $21 billion, CEO John T. Chambers recently told shareholders that "if dividends were certain not to be double-taxed, we would look at [declaring a dividend]." If others followed, and investors over time warmed to stocks with a hefty yield, companies may view the once-dowdy dividend as the best way to bring some sizzle back to their tired stocks.

By Dean Foust in Atlanta, with Howard Gleckman in Washington and Jim Kerstetter in San Mateo, Calif.

    Before it's here, it's on the Bloomberg Terminal.