The Bush proposal is not actually a tax cut on dividends. It is more accurate to say that it eliminates the double taxation on corporate profits. Corporate profits are not taxed twice, whether they are paid out as dividends or are retained earnings and capitalized in the share price. Therefore, the Bush eliminates the double taxation on dividends, and lowers the capital gains tax to the extent that earnings are retained. Much of the discussion which follows is from a WSJ article this week.
Company XYZ earns $10 a share and pays $3.50 in federal taxes. That leaves $6.50 a share in after-tax profits to be paid out in dividends or re-invested in the business.
Dividends are tax free as long as the company has paid taxes. The company will notify investors (1099?) on their standard annual dividend statement about how much of their dividends are tax free. Since real estate trusts don't pay taxes, their dividends would be taxed.
What about companies who don't pay dividends? Say a share of ABCD is bought for $100 and the company has $6.50 in fully taxed profits that year. The company will notify the shareholder of this fact, and the shareholder can increase the cost basis to $106.50. If the shareholder sells the share for $110, then the capital gain is only $3.50.
This clever plan was written by Glenn Hubbard, currently chief White House Economist, in 1992 when he worked in the first Bush administration. Note that it accomplishes the stated goal of eliminating the double taxation of dividends, it provides a reduction in the capital gains tax, and it encourages but does not force companies to pay a dividend.
One of the objectives of this plan is to improve corporate governance. In the 1970s, Carter wanted to eliminate the double taxation of dividends. Even the NY Times supported it!!! However, Carter (and even Reagan) gave up because business lobbyist were opposed to it. Corporate management doesn't want to pay dividends. They would prefer to retain earnings and tell investors about how good business is going to be according to GAAP/Pro Forma paper earnings. Now companies no longer have an excuse for not paying a dividend. Investors will demand a dividend and companies will have to pay it.
If the Bush plan becomes law, the only companies which will not be required (by the market) to pay dividends will be small, developmental companies which need to retain all of their earnings to grow. All others will have to pay a dividend in order to support their stock price.
Andy Bryant, CFO at Intel, made a curious statement the other day. He said that Intel always managed their business to maximize cash flow, not paper (GAAP/pro forma) profits. The Bush plan will make monitoring cash flow much more important than it is now. Investors will still be concerned about how a company will perform in the future, but there should be little doubt about the company's current performance, because a company which has a negative cash flow will quickly cut or eliminate their dividend. |
