The Real Effect of Tax-Free Dividends
January 7, 2002
The biggest news of the day is the buzz behind President Bush's economic stimulus plan. While the plan itself is multi-faceted, the part we're most interested in is the potential repeal of dividend taxes. On the surface this sounds like a great benefit to stocks. However, experience has taught many of us that hype is a powerful, yet short-lived, market force. A closer look is warranted.
The theory is that investor's bottom lines would be increased in when more of their investment income would stay in their pocket rather than get paid out in taxes. And when investors have more money in their pocket, they are more likely to spend it, and thus stimulate the economy. All of this is true. Unfortunately, it's also true is that most investment income is derived from capital gains, which will still be taxed at their current rate (as of the most current plan). On average, only about 5 percent of personal income is created by dividends. On top of that, much of that 5% is earned in tax-free retirement accounts already. So the immediate impact of a dividend tax repeal may be minimal, if even noticeable.
That issue could be somewhat helped if more companies started paying dividends, which many investors think will happen. But the tax benefit is currently only extended to the individuals who receive dividends. The companies who pay them are still going to be taxed as usual. In fact, it's a lose/lose situation for most corporations - not only would these companies sacrifice tax-free resources that could be used in research, development, and business growth, they would subject themselves to taxation just by paying shareholders. Knowing this, it's not likely that many companies will now opt to pay dividends if they haven't already.
So, the issue now becomes one of finding companies that DO pay dividends. Ultimately, though, the issue becomes one of how much shares are yielding (paying) on a percentage basis. The current average yield on stocks is about 1.5 percent, but that can go as high as 6.0. Let's say for the sake of argument that yields are about 5 percent. That means that if a share is $20, then the annual dividend is $1. Although most dividend paying companies earn slightly more than they actually pay out, let's assume that profits and the dividend are equal. If the demand for these shares goes up causing the per-share price to go to $40, how much will the company be able to earn and payout per share? Not $2...the earnings are only determined by how well the company performs. The price of these shares, and therefore the yield, are determined only by investors who buy and sell these shares. If you pay $40 for a stock, you still can't make the company do any better than the $1 per share they were earning. With your yield now at 2.5 percent, owning that stock doesn't seem as attractive.
This is not to say that the entire stimulus package is a bust. In fact, there are some great features of the plan that are going to put a lot of money back in the pockets of taxpayers. And even the dividend tax repeal is a boost. It's just important that we understand the real impact of dividend taxation removal, and not overestimate what the long-term and short-term effect will be. There's a lot of hype about today's announcement. I encourage all of us to consider it logically, and not get swept up in the frenzy.
from: Price Headley's Daily Trend Watch |
