Doubling Up The Debate On Dividends

Author: Jerry Knight

Published: December 16, 2002

Washington investors considering end-of-the-year adjustments to their portfolios need to work a new factor into their calculations -- dividends.

Remember dividends? Those are little checks some corporations send out every quarter giving stockholders a share of their profits.

Nobody has paid much attention to dividends for years, and for good reason: They often don't amount to much. The average dividend yield, which is the dividend amount divided by a stock's current market price, on the companies in the Standard & Poor's 500-stock index was just 1.74 percent as of last week.

The way to make money on stocks had been capital gain -- the profit you earn when the value of your stock goes up.

Dividends are about to make a comeback. Not, as you might think, because stocks haven't been going up, but because the Bush administration is pushing tax law changes that could make collecting dividends much more attractive to investors.

They're talking about finally doing something about "double taxation" of dividends, an issue that has irritated investors and tax reformers for decades.

Dividends are deemed to be taxed twice because corporations pay income taxes on their profits. When they pass part of those profits on to stockholders, the stockholders pay taxes again on the dividends.

"Double taxation of corporate income has long been on Treasury's list of inefficiencies and distortions in the tax system," said Gene Steuerle, an economist and tax expert at the Urban Institute.

Taxing dividends twice distorts the economy because it discourages investors from wanting them and discourages corporations from paying them, Steuerle explains in a recent issue of Tax Notes.

The Route to Reform

What will be done about it isn't clear at this point, but President Bush has put the issue on the table. The president is talking about attacking double taxation as part of the $300 billion economic stimulus package he wants Congress to pass early next year.

People working on the package say it's highly likely that some reform of dividend taxes will be part of it. Nobody's counting on Congress to totally eliminate double taxation. That would cost too much, cutting government revenue by at least $25 billion this year and maybe twice that much, depending how it's done.

There are several ways to attack the issue. Which approach the White House and Congress come up with will determine not only how much investors save in taxes but also how it affects the market and the economy.

One solution is to give corporations a tax deduction for dividends they pay. Allowing companies to deduct dividend payouts from corporate income eliminates one of the two taxes. But that gives the benefit to corporations, rather than individuals, which makes it less appealing politically.

It's also inefficient because roughly half of all corporate dividends are paid to pension funds, retirement accounts and others that don't pay taxes anyway. Curing the problem at the corporate level would double the revenue loss to $50 billion a year.

What's more likely is that Congress will attack the issue at the taxpayer level, either by exempting some dividends from taxes, reducing the tax rate on dividends or giving investors a credit for the tax already paid by corporations on the dividends they receive.

Until a few years back, the tax code gave individual investors an exemption from taxes on part of the dividends they received. The size of the "dividend exclusion" varied over the years; most recently it was $200 for an individual, $400 for a couple filing a joint return.

That wasn't a lot, but it provided an incentive for people to invest enough of their savings in dividend-paying stocks to generate at least $400 a year in tax-free income.

This time around, tax writers are talking about a much bigger exclusion than $400. That token amount doesn't accomplish anything as far as tax reform is concerned, and it gives investors a very limited incentive to buy stocks that pay dividends.

Another approach would be to give individual investors a credit for the corporate taxes already paid on their dividends. That gets complicated in a hurry. Dividend checks would have to come with an explanation of how much tax the company paid and investors would have to plug that into their own tax returns.

Or Congress could simply reduce the tax rate on dividends. One suggestion is to make it the same as the rate on long-term capital gains -- equalizing, advocates argue, the taxes on the two forms of stock profit.

This, too, gets complicated. Special forms are required to figure taxes on capital gains, and tax writers are reluctant to require people to fill out yet another schedule for their dividends.

Hardly Equal

But taxing capital gains and dividends at the same rate doesn't really equalize the appeal of the two forms of stock market profit, cautions Joel Dickson, a principal and tax specialist at the Vanguard Group, the big mutual fund family.

"Even if dividends are taxed at capital-gain rates, you still have the issue that capital gains are preferred," Dickson said. "With capital gains, you can always defer the tax" by not selling your stock.

"That still makes capital gains more attractive," he added, "but a little bit less attractive than capital gains are today."

Taxing dividends and capital gains at the same rate doesn't eliminate "double taxation," either, it just reduces it, said William G. Gale, a tax specialist at the Brookings Institution. Nor is there any real reform involved in giving investors an exemption from taxes on part of their dividend income.

Gale argues that there are three reasons to cut taxes: to stimulate the economy, to reform the tax system, and to cut tax revenue so the government has less money to spend.

"The administration is using the first two arguments," he said, "but I sense their real reason is the third."

If stimulating the economy is the goal, he said, then giving corporations a tax deduction for dividends is most effective, because it directly increases corporate profits, giving them more money to spend.

In terms of overall tax policy, Gale wants to close corporate loopholes and tax shelters before eliminating double taxation of dividends, but that's another debate.

There is widespread skepticism among economists in Washington and on Wall Street about whether ending double taxation of dividends will do much to stimulate the economy.

Much of the tax cut would go to wealthy investors, who economists say are unlikely to go out and spend the money they save in taxes. Unless the money is spent, the economy doesn't benefit. If taxes on dividends are cut next year, most taxpayers won't notice until they prepare their 2003 taxes in April of 2004. That lag delays whatever stimulus effect there may be.

Sharing the Wealth

But as a tax reform, the idea has wide bipartisan appeal. The last big push for it came from President Jimmy Carter.

Despite all the years of discussion about ending double taxation of dividends, there is very little agreement on how it would affect investors' choices, the stock market or the willingness of corporations to pay dividends.

"It's a nice idea for individual investors, but not a big deal otherwise," said David Blitzer, the chief economist for Standard & Poor's. "People love to find things that they don't have to pay taxes on."

Blitzer theorizes that ending double taxation of dividends would produce "some shift from sector to sector" as investors move out of industries where dividends are rare, such as high tech, and into utilities, banks and other businesses where most companies do make payouts.

Logically, investors ought to increase their appetite for stocks that pay dividends if they get a break on taxes. Would investors become so eager for low-tax or no-tax dividends that they would be willing to pay higher prices for stocks that pay dividends? Maybe a little, most economists think.

"The removal of double taxation could have a smaller, or more drawn-out, impact on equity valuations than is generally expected," Richard Bernstein, chief U.S. investment strategist for Merrill Lynch & Co., said in a report on the topic last week.

Bernstein is skeptical of the theory that dividend tax reform would create such strong demand for dividends that corporations would be under pressure to pay bigger dividends.

Still, some analysts buy that theory. They say it would put heat on profitable, cash-rich companies to start sharing the wealth with their stockholders.

Everybody's favorite example is Microsoft Corp., which has about $40 billion in cash but has never paid a dime of dividends. Microsoft and other no-dividend, high-tech companies traditionally argue that their shareholders are better off if the companies keep the cash and reinvest it in new ventures.

Lobbyists for companies like Microsoft could play a crucial role when Congress starts debating double taxation in the economic stimulus package next year. High-tech companies may fight it, and other business groups that have long denounced double taxation of dividends may not make the issue a priority.

That's what happened when Carter raised the issue in the 1970s.

At that time, business groups were lobbying for a whole basket of tax cuts. When Congress told them they couldn't have everything they wanted, business lobbyists dropped the dividend issue. The interests of the companies took priority over the interests of shareholders.