Stupid Idea From The Bush Administration
January 8, 2003
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"
However, the dividend tax cut will hurt the economy, crush
the stock market, reduce technological innovation with little
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
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.