Editors mixed on Bush econ plan Hard to gauge the impact of dividend tax cut on stocks
By Mark Hulbert, CBS.MarketWatch.com Last Update: 12:38 AM ET Jan. 7, 2003
ANNANDALE, Va. (CBS.MW) -- The stock market clearly likes what it has heard so far about President Bush's economic stimulus plan. On Monday alone the Dow Jones Industrial Average rose by 2 percent and the Nasdaq Composite by 2.5 percent.
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Louis Navellier, editor of Louis Navellier's Blue Chip Growth Letter, gives the lion's share of the credit to Bush's proposal to eliminate the income tax on dividends: "Dividend tax relief is going to help the stock market more than anything that I will probably ever see in my lifetime... This is a very, very bullish event."
Dow Theory Forecasts' Richard Moroney is not so sure: The "dividend tax cut [is] no panacea." Its impact on the stock market will be quite modest, he predicts.
Who said that it was easy figuring out how Washington politics will affect the stock market?
After reading what investment newsletter editors have said about dividend tax relief, I am reminded that economic modeling is difficult even in the best of circumstances. But it is especially difficult when attempting to assess the impact of dividend tax relief.
Consider the following questions that must be answered when attempting to gauge the impact of a dividend tax cut:
Will the tax reduction come at the corporate level or the individual level?
The impact of dividend tax relief will be far different if it comes at the corporate rather than the individual level. At the corporate level, for example, dividend tax relief encourages firms to increase their dividend payout ratios, which in turn supports higher stock prices.
Dividend tax relief for individuals, in contrast, does not directly affect corporate balance sheets. Instead, it increases the after-tax yield of owning dividend-paying stocks.
Most would agree that eliminating the corporate tax on dividends would have a larger and more lasting positive impact on the stock market than providing dividend tax relief to individuals. Yet this is not what President Bush has proposed.
Standard & Poor's Chief Economist David Wyss speculates that political considerations kept Bush from proposing dividend tax relief at the corporate level: "It wouldn't play well because it would be a break for corporations rather than individuals."
Instead, Bush has proposed eliminating the individual income tax on dividends. Of course, he may not succeed in convincing Congress to go alone with this elimination. But even if he does, several other questions must be answered before we can determine the extent to which it will increase the level of the overall stock market:
What portion of the dividends that companies distribute is received by taxable accounts?
Though no one knows the exact answer to this question, it is undeniably large. According to Standard & Poor's Wyss, "about half of [all] dividends [in this country] are received by tax-exempt entities like pension funds." For them, needless to say, the elimination of the income tax on dividends will be a non-event.
Still, once their dividends no longer are taxed, taxable investors -- in theory -- should be willing to pay more for dividend-paying stocks.
The key phrase here is "in theory." This leads to yet another follow-up question:
How will the taxable investor actually react to the elimination of the income tax on dividends?
The answer to this question is not at all clear. A whole generation of investors has grown up on the notion that dividends hardly matter, believing that almost all of a stock's total return comes from price appreciation. An increase in the after-tax value of a company's dividend is unlikely to lead these investors to make appreciably different investment decisions.
In fact, nearly two-thirds of all publicly traded companies do not pay any dividend whatsoever. This is because, as Dow Theory Forecasts' Moroney reminds us, so many investors "are willing to sacrifice current income for the prospect of superior share-price appreciation."
Even among taxable investors who do focus on dividends, furthermore, there are many who are unaccustomed to basing investment decisions on after-tax equivalencies.
Witness the nearly complete obsession in the mutual fund world on pre-tax returns. These investors therefore may continue to judge a stock by its nominal yield, which will not change under Bush's proposal.
There is yet another complicating factor in trying to assess investors' reaction to dividend tax relief:
How will investors react to the prospect of the federal government losing $600 billion in tax revenue?
I am not staking a political position in asking this question. It may very well be that the President's proposal will so stimulate the economy that the IRS will more than recover the tax revenue otherwise lost because of this new stimulus package.
Instead, I am questioning what investors' psychological reaction will be.
If, rightly or wrongly, they believe that Bush's stimulus package will lead to higher government deficits, which in turn will retard economic activity, their behavior will tend to counteract the stimulating effect of Bush's package. (I owe this insight to John Brynjolfsson, portfolio manager for the Pimco Real Return Bond Fund.)
This possibility is well known among economists, who refer to it as Ricardian Equivalence. It is named for the 19th century British economist David Ricardo, who noted that we behave in ways to smooth out our consumption patterns over our lifetimes.
This is why government tax cuts often fail to provide as strong an economic stimulus that economic models otherwise predict.
What's the bottom line?
With so many imponderables, it is not surprising that so few are hazarding even a guess about the impact of dividend tax relief on the stock market.
The most specific forecast I have come across comes from Pimco's Brynjolfsson. His models have led him to conclude that dividend tax relief will cause the fair value of equities to rise by 3 percent to 5 percent.
That's nothing to sneeze at, of course. But Monday's rally alone comes within shouting distance of meeting the low end of this forecast.
That may mean that the stock market has already discounted the bulk of the positive impact of Bush's dividend tax relief.
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Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980
