A Strange Spur for Corporate Spending

In a daunting leap of logic, Bush says cutting taxes on dividends will open businesses' purse strings. Can these dots be connected?

By Amey Stone

As the centerpiece of President George W. Bush's plan to stimulate the economy, the proposal to eliminate taxes on dividends has a lot of investors and economists scratching their heads. In his Jan. 7 speech outlining the plan, Bush explained: "By ending double taxation of dividends, we will increase the return on investing, which will draw more money into the markets to provide capital to build factories, to buy equipment, to hire more people."

Sure, politicians want to put the best spin on their proposals when they unveil them for the public. But that particular statement is in serious need of some parsing.

It takes several leaps of faith for a cut in dividend taxes to result in more capital spending by businesses. Eliminating this tax would have a direct effect on investors and should immediately raise the value of dividend-paying stocks -- estimates are that the market as a whole could rise 5% as a result. But the move likely wouldn't directly influence capital-spending decisions. After all, it's CEOs, not investors, who determine whether to build factories, buy equipment, or hire more people.


  Corporate chiefs choose to spend money on expansion for two basic reasons. One is that they need more production capacity -- but with industrial capacity utilization running at only about 75%, few businesses are likely to feel this need anytime soon, dividend tax cut or not.

CEOs also spend because they're willing to take the chance that additional demand is about to materialize. But given the current high level of geopolitical risk -- especially the threat of war with Iraq -- and the crackdown on shoddy corporate governance practices, industry leaders have been moving gingerly for the past year. Cutting the dividend tax is unlikely to encourage them to run out and take on more strategic risk.

Instead, one consequence of Bush's plan could be to encourage even more conservative behavior from the corporate suite. "One senses that to the degree investors demand payment of cash dividends, then companies might become more cautious with their use of retained earnings and cash, and, therefore, more risk-averse," says John Lonski, senior economist at Moody's Investors Service.


  Eliminating dividend taxes could also pull much-needed capital away from fast-growth (non-dividend-paying) companies because investors would be more drawn to mature, stodgy utilities and local phone carriers that shell out the most in dividends. "The logical outcome is that investors will reward companies that are very slow and stable, big and bureaucratic," says Peter Cohan, an author and management consultant in Marlborough, Mass.

Advocates of the Bush plan argue simply that it would prompt more investors to return to the market, lifting stock prices, which should then encourage more risk-taking. Leaving cash in a money-market account won't seem so smart if a stock, which has opportunity for capital appreciation, has a higher, tax-free yield, points out Bill Meade, a managing director at RBC Capital Markets.

Here's how the plan's fans connect the dots between a boost in stocks and an increase in corporate spending: With more money flowing into stocks, they argue, businesses could have an easier time raising capital by issuing more stock or, in the case of startups, by going public. Furthermore, if stock prices rise, it might have an accompanying psychological effect on corporate leaders, who might start spending more.


  Likewise, investors (who now represent 50% of the population) would feel better, and they might spend more. So even consumer spending would get a boost, creating more demand for goods. It's a nifty virtuous cycle. However, these scenarios have a lot of ifs, and such salutary results could easily be derailed if the economy weakens or a geopolitical crisis ensues.

Other policy changes would have a more powerful stimulatory effect on business spending, experts say. "What would really help us in high tech is a sharper tax break on capital-equipment spending," says Magdalena Yesil, a general partner at U.S. Venture Partners in Menlo Park, Calif. (The Bush plan includes a tax break on capital-equipment spending, but one that's much smaller than many tech execs had hoped for.) Of the dividend cut she says: "It's a stimulus, no question about it. But for the industry I represent, we would benefit more from other types of stimulus."

Cuts in capital-gains taxes are traditionally regarded as the way to stimulate investment in growth industries. And sure enough, the Bush plan includes a little-understood provision that would supply some capital-gains tax relief to investors in businesses that chose not to pay their dividends in cash. But while that feature has some tech investors excited, it adds a whole new level of complexity to the tax code and underscores how far politically the White House's proposals are from becoming reality.


  The real explanation for why dividend cuts are the centerpiece of the Bush plan is political, not economic, argues management consultant Cohan. Dividend tax cuts are a probusiness policy that corporate leaders have wanted to see for a long time. From their perspective, lowering taxes is a good idea in principle, and so the move is a way for Bush to please his fans in the corporate suite.

As long as other risk factors plaguing the economy remain at bay, the maneuver might indeed do some good. But as far as triggering more corporate spending, eliminating taxes on stock dividends is far from a magic bullet.

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Beth Belton