With the help of two Democrats, the Senate handed President Bush a possible victory: a temporary repeal of the double taxation of dividends as part of the economic package. Under the provision, investors could exclude 50 percent of dividend income from taxes this year and 100 percent of such income in 2004, 2005, and 2006. If the measure goes through, the hope is that it will become permanent because Congress isn’t likely to allow the measure to expire in 2007.
The real showdown will come as the Senate and House meet in conference to try to hammer out a compromise. But the Senate’s action raises a number of interesting investment implications. In particular, how differently will investors and corporations behave if the dividend provision is sunsetted — and if it is not?
The math on the elimination of the double tax on dividends is quite simple. Under current law, $100 worth of earnings paid out as a dividend is subject to a 35 percent corporate income tax, leaving only $65 to be paid out as a dividend. In turn the $65 dividend is taxed at the 38.6 percent ordinary income-tax rate, netting the shareholder only $39.91 in after-tax income. Since the Senate plan eliminates the corporate tax and taxes the dividend at the new 35 percent rate, shareholders will receive $65 (per $100 of earnings) in after-tax income. The shareholder take increases by 62.9 percent.
So, what if these tax rates become permanent?
In the proposed Senate tax bill, dividends are no longer the least advantaged return-delivery mechanism for a company. A clear implication of a permanent dividend tax cut is that corporate income will become more valuable on an after-tax basis. Hence, the value of both corporate debt and corporate equity should rise. Stated another way, the cost of capital will unambiguously decline, and valuation and investment should increase. A permanent adoption of the Senate bill will be quite bullish for the economy and the markets.
The investment implications are fairly straightforward. Corporate structure will change in a predictable way. In order to maximize the after-tax income of shareholders, corporations will now decrease the relative importance of the least tax-advantaged vehicles — retained earnings — and increase the exposure to the most advantaged. There will likely be a rise in dividend payments, as well as corporate debt at the expense of retained earnings. Since, on a relative basis, dividends will gain the most, there will be a surge in dividends in both absolute and relative terms. Absent any regulatory or governance cost, corporations will increase their dividend payouts. Retained earnings will decline over time.
Corporate structure is not all that will change. Corporate investment choices will also be altered as companies undertake projects that generate dividend income. In order to minimize corporate tax liabilities, corporations may either issue debt and/or issue new stock to finance their investments. Either of these two alternatives may be cheaper than retaining earnings. With the Senate package, the effective tax rate on retained earnings will be 48 percent versus 35 percent on corporate debt. So, it will be optimal for a business to finance new projects out of retained earnings only when the cost of issuing new debt or new equity is greater than 13 percent of the income generated by the new investment. It follows that underwriting activity will greatly increase because of the new investment opportunities, and also because of the choice of financing (i.e., avoiding retained earnings), and that dividend reinvestment plans will become more popular.
But what if the tax-rate changes are temporary?
A temporary change in the tax law, even one that is fully anticipated, will not produce many of the positive long-run effects that the original Bush plan would have delivered. However, sunset provisions do not mean all is lost. A temporary tax-rate cut will have the benefit of “unlocking” capital.
In the past, capital held by individuals has been unlocked when capital-gains tax rates have been lowered. Even a temporary lowering of the capital-gains tax rate has led investors to unlock their gains and redeploy them in activities delivering a higher rate of return. The analogy holds here. Right now, corporate retained earnings are locked by the current tax laws. So, the Senate proposal, even if temporary, will allow corporations with existing cash to “unlock” their capital by paying out dividends. The moral here is that if the tax-rate change is temporary, pressure will mount for cash-rich corporations — including those that have not done well in their portfolio investments — to pay “one time” dividends sometime between now and the time the lower tax rates are due to expire.
The Senate package will alter the after-tax income delivered to investors. The changes in tax rates increase both the after-tax returns of dividends and corporate debt, without harming or benefiting the tax treatment of retained earnings. The changes will generate two types of political pressure: Higher after-tax returns will create pressure to make the tax-rate changes permanent, and the differential tax treatment will create some political pressure for a fair and equal treatment of retained earnings.
If the pressure mounts to a high-enough degree, as it should, the Senate proposal will become permanent (and sometime in the future it will be extended to retained earnings). The U.S. will be much better for it.