Dividends again: When earlier I posted that this was too complex to pass, I had not really looked at all the complexities...the article below does. I continue to post perspective on this since something will get passed and it WILL have a significant impact on investing strategies.
The Eye-Popping Complexities Lurking in the Bush Tax Plan
online.wsj.com
>>1/16/03 THE MACRO INVESTOR By STEVE LIESMAN WSJ
When I first got the little scoop concerning President Bush's proposal to eliminate the dividend tax, I couldn't wait to get on the air and report it.
But then I hesitated. Thinking about it, I couldn't conceive of a way to make it understandable for television, much less for this column. Then I figured investors probably wouldn't need to know it anyway. That's because this little nugget of accounting intricacy told to me by a senior Treasury official makes the entire proposal so complicated that Congress will never approve it in its current form.
So, if you don't want to read the gory details, you can skip to the section below about the administration's statistical sophistry concerning senior citizens and dividends. But, before you skip on down, take this idea with you: the quietly proposed capital-gains reduction that's part of the plan to eliminate dividend taxes is unlikely to pass. The reason: It's a nightmare of complex record-keeping that would only cheer an accountant.
"It isn't going to be in there,'' predicts Andy Laperriere, who watches these things for ISI Group in Washington. "Even though economically it makes perfect sense, it will look like a back door way of cutting the capital-gains tax.'' Mr. Laperriere thinks the capital-gains tax cut is fodder for compromise that President Bush will use to get the rest of his plan through.
So, if the plan passes the way Mr. Laperriere now thinks likely, stocks that pay dividends will be far more attractive than companies that don't pay dividends, instead spending that money on their businesses, providing investor return through stock-price appreciation. In effect, the tax code will invert the old distortion that previously favored nondividend paying companies.
(For fairness purposes, I should add that when we recently interviewed Glenn Hubbard, the president's top economic advisor, on CNBC, he was giving up on nothing. He insisted that the president saw no reason for compromise.)
The Gory Details
OK, for those of you geeks that find this stuff interesting (myself included), here are the messy details that are likely to sink the capital gains part of the dividend tax-cut plan:
As you probably know by now, the current proposal to eliminate the dividend tax has two parts. The first is the elimination of the dividend tax. The second is the quasi-elimination of the capital-gains tax.
The administration had to do this because otherwise it would create an incentive for companies to pay out dividends rather than invest in their businesses. Stocks in theory are supposed to rise to account for invested profits, providing the investor with a capital gain.
But you see, if the capital-gain tax remained at 20% while the dividend tax was eliminated, then shareholders would prefer the dividend to the invested profit and companies would have a strong incentive to pay out a dividend rather than invest in their business.
Mr. Hubbard's solution: reduce the capital-gain tax by the amount of invested profit. In practice, this means increasing the basis of the stock by the retained earning. Say you bought a stock for $10 and the company invested $1 of retained earnings. When you went to the sell the stock your basis would rise by $1 to $11. If the stock were sold at $11, you would pay no capital-gains tax. Now you would pay 20 cents (the 20% capital-gains tax.)
But there was a considerable hitch. What would happen to a company in a cyclical business if (not really if, but when) it had a down year? Say there were no after-tax profits? The company couldn't pay a tax-free dividend.
Because the administration insists in its proposal that tax-free dividends only can be paid from "taxed" profits, a company that investors thought would pay a tax-free dividend, would now pay a taxable dividend if it paid one at all.
I called the Treasury to find out and here's the little wrinkle they told me about: a tax-free dividend could be paid up to the amount of last year's retained earnings. But, the company would have to go back and retroactively decrease a shareholder's basis. Got that?
This is so complicated as to almost defy an example. But let me try.
Year 1: A company earns $10 per share. It keeps $3 a share to invest in its business and pays a $7 dividend.
The investor receives a $7 dividend and a $3 increase in basis with which to reduce capital gains.
Year 2: A company earns nothing. Now, the company can pay a tax-free dividend up to the amount of last years' retained (invested) earnings of $3 a share. But, it must now go back and reduce the shareholder's basis by that amount.
I really want to hand it to Glenn Hubbard and Pam Olson, who heads tax policy at the Treasury, for thinking this proposal through seriously and trying to combine good finance and economics. All of this makes sense. If they didn't take away the basis increase in year one, then a shareholder would "double-dip," receiving a basis increase in year one and a tax-free dividend in year two. But let me use the gentle words of Mr. Laperriere of ISI Group who would not say the plan is complicated, only that it's "administratively burdensome.''
I guess I can call it a mess, and I admit I don't know how it can be accomplished more simply.
Mr. Laperriere believes the result would be that dividend taxes will be eliminated but the capital-gains tax will be unchanged. So there will be a slight distortion in favor of dividend-paying companies vs. those that retain and invest their earnings. But it's not really 20% vs. zero. For a variety of reasons the effective capital-gains tax is actually, on average, quite a bit less. Some economists say it's 10%.
So the resulting distortion in the potential absence of a capital-gains tax cut is actually better then the current distortion.
Double taxation of dividends means that some corporate earnings are taxed at 60%. A capital gain is taxed at 20%, creating a 40 percentage point difference.
If the dividend tax is eliminated and the effective capital gains at 10% is left unchanged, then there's only a ten percentage point difference.
Dividends and The Elderly
While I find the Administration's dividend-tax proposal messy and complex, I've got some sympathy for the idea of cutting the dividend tax. It's a good thing to eliminate economic distortions that result from tax policy. We can argue over whether this is the best time to do it and whether offsetting spending cuts should be part of the plan. But the essential idea of eliminating the double taxation of dividends has merit.
What I don't have sympathy with is the way the President is trying to sell this as a relief package for the elderly. It isn't.
In introducing his package, the president said that half of all dividends go to the elderly. What he didn't say was that data provided by the non-partisan Congressional Research Service shows only 21% of all the elderly receive dividends. That means that the bulk of the dividend tax relief goes to a select group of senior citizens and 79% of all elderly get no break from this part of the plan.
"The concern that including dividend income in the individual income tax disproportionately affects the elderly does not appear to be supported by either economic theory or the empirical evidence,'' the CRS said, noting that 58% of this group received dividend income. The administration tacitly acknowledges this. In its fact sheets about the impact of their cuts, one line reads, "Among those with tax cuts would be 7 million elderly taxpayers whose taxes would decline, on average, by $1,252.''
Guess what? 7 million is roughly 21% of the 35 million people that the Census Bureau says are aged 65 years and older in this country. If you're interested, for the same tax relief that Mr. Bush provides for this group of seniors, he could give a check to every senior for $261.
Mr. Bush should sell the proposal on the merits and not engage in vote-getting fuzzy math -- the same kind of which he once accused his opponents. |
