Another Stupid Idea From The Bush Administration
January 8, 2003
By Hochizen

The idea that taxes should be cut on dividends is a major part of the economic policies of the Republican administration, seeking to once again give a huge tax break to their major donors at the expense of the American economy and the vast majority of its citizens.

For the time being, let us ignore the allegations that this tax cut will primarily benefit the wealthiest Americans. Should it be shown that this tax cut to the wealthy will spur the economy, then it would be a good policy, questions of "fairness" aside.

However, the dividend tax cut will hurt the economy, crush the stock market, reduce technological innovation with little benefit.

First let us look at the results of a 50% tax reduction on the rate paid by recipients of dividends. What will the result be? The prices of stocks are ruled by supply and demand. Right now, dividends are not particularly desirable. The taxes do cut deeply into the ultimate return provided by dividend paying stocks. When the tax cut becomes law (actually, even before the tax cut becomes law) the stocks with a high dividend yield will become much more desirable since the rate of return will be increased. According to the laws of supply and demand, the price of these stocks will go up, thereby dropping the yield on these stocks to a rate corresponding to the risks perceived in owning them. In other words, the price of certain dividend paying stocks will definitely rise. While this will be good for those who own these dividend paying stocks, it will be bad for those who hold bonds. After all, if the yield on bonds is not increased by a corresponding amount, bonds will be less desirable than dividend paying stocks which provide a partial tax shelter. Similarly, cds and bank notes will be less desirable. The result will be an increase in the yield of bonds and cd's to represent the increased pressure on these markets caused by the attractiveness of dividend paying stocks.

Guess what happens when the interest rates on bonds and cds go up, boys and girls? That's right, real interest rates go up, because banks are not going to lend money at a rate less than they pay. So, the tax cut on dividends will push the economy towards recession. In a weak economy, adding pressure towards weakness is insane. Corporations are already leery of expanding, of hiring more workers and of building new plants. If the price of credit is higher (due to higher bond rates the corporations could float, or due to higher bank interest rates) they will be even less likely to expand.

Furthermore, the tax cut will make it more difficult for local governments to float bond issues for improvements such as water plants, schools, or other needs. The yields of municipal bonds are quite low, because of their favored tax status. If part of that benefit is lost by stock dividends having a sheltering effect, then municipal will have to increase their yields to find buyers. Of course, this means the cost to the taxpayers will increase as the higher bond interest rates will have to be paid.

Not only is a dividend tax cut recessionary, it will also crash the stock market further. If stocks do not pay dividends, they will be less attractive. Growth stocks tend not to pay dividends, under the theory that they are better able to use their capital to expand. Therefore, most growth companies will see their stock price fall. Growth companies are also at the forefront of technological innovation...after all, Krogers has little reason to spend much on research and development, but Intel has great incentive to do so. The technology stocks (and other growth stocks) will face a dilemna: should they pay dividends, and thereby use capital that could otherwise be used for growth or research and development...or should they not pay dividends, and watch their stock price take a hit?

Perhaps one of the hardest hit stocks will be the new companies. Since stocks which do not pay dividends will be less attractive, new companies will see their initial stock offering price lower than it otherwise would be. There will be less capital resulting from the IPOs, which will mean it will be more difficult to start up a company. The start ups could forgo the price hit by paying dividends... but again, they go public to get capital to grow the business, and tying up money by paying out quarterly dividends will only limit their opportunities.

In a nutshell, then, we will see a dividend tax cut that will likely increase recession pressures, lower the prices of most stocks and stifle innovation and growth. The tax cut will put pressure on governments to increase yields on bonds which will cost all of us more money.

The only benefit would be that those who hold the stocks will see price appreciation and have more money. Of course, most people do not only hold dividend paying stocks..so their benefit will be offset to the extent they own non-dividend paying stocks or bonds which will see their price decline.

The proposed legislation is simply bad business. The effects could be ameliorated somewhat capping the tax break to the first $2,500 of dividend income. This would lessen the negative impact on the economy and the rest of the market. This would NOT be "class warfare;" it would be a benefit that would be available to everyone. It would stop the expected outflow of major money away from bonds and growth stocks..it would not be as inflationary...and it would increase interest of the average investor in returning to the market.

Of course, we know the Republicans don't really care about those things. After all, they need to payback their rich handlers at any cost -- even if it tanks the economy, the stock market and technological innovation.