An overwhelming number of economists and market prognosticators hail the tax reduction on cash dividends as a major step in increasing investor interest in the stock market. Yet, CNBC tells us that since the tax cut has been enacted, low- or no-dividend-paying stocks have outperformed dividend-paying stocks. Maybe the market anticipated the change in the tax rates or maybe the market is telling us that the future is in non-dividend-paying stocks.
For companies that have already embarked upon a cash-dividend strategy, the after-tax benefits of a lower tax rate on cash dividends may be good business policy since individuals are being taxed twice on their corporate profits — once at the corporate level and then at the individual level. President Bush had the right idea when he proposed tax-free dividends, but unfortunately Congress didn’t agree.
However, the idea that corporations should now increase cash dividends because of the change in tax law is another matter.
First of all, no matter how you slice it, cash dividends deplete corporate wealth. At a time when corporations are just emerging from a serious corporate recession, pundits are encouraging companies to pay out more cash while, at the same time, encouraging them to increase capital spending. I guess they can borrow to accomplish that, but using retained earnings to expand makes more sense.
One other big problem is that the “increase dividend payout” strategy may very well increase tax payments on an aggregate basis. Prior to dividend increases, investors could choose whether or not to pay taxes by selling shares to produce income rather than getting a cash dividend. Now they have to pay taxes on increased dividend payments even though they may not want the cash. In an article I wrote for NRO last year, I noted that Ralph Nader demanded that Microsoft declare a cash dividend so that the government would collect its fair share of taxes. Maybe he’ll have the last laugh after all.
Another new complaint arising from the liberal side of the aisle is that increased dividends will benefit wealthy investors, especially those who own substantial amounts of company stock. Unfortunately, you can’t help the little guy by lowering the tax on dividends without helping the big guy who holds a lot of stock.
But another way to satisfy shareholder needs for cash is to adopt a systematic stock dividend strategy. For example, a company like Microsoft could pay a 1 percent stock dividend each quarter for an overall 4 percent “yield.” Shareholders could either cash the stock dividend by selling the stock or hold it — effectively getting the entire dividend tax-free. In today’s modern world of Internet trading, sale of such stock has a minimal cost. This option makes much more sense than the idea of a dividend reinvestment program, where the investor has to first pay a tax before being able to reinvest in the company.
There are other advantages of a stock dividend strategy. For example, the company retains cash to invest in the business and grow the company, thus contributing to the probability that the company’s stock will rise in price over time and thus tax sheltering wealth until a future time period.
The investor can now choose whether or not to convert the stock dividend to cash and pay tax now, or keep the dividend and hold more company stock — deferring tax payments until such time in the future when cashing-in is the preferred option. If the investor sells the stock dividend, the taxes due would be at most at the capital-gains tax rate, but it could be lower since some of that stock sale could be considered principal.
For growth companies that have high returns on equity and the opportunity to increase shareholder wealth by reinvesting income, a stock dividend policy makes a lot more sense than paying out cash. Well, it makes more sense for the company and the shareholder, but not for Uncle Sam — at least according to Ralph Nader.
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc. and an investment consultant for Wealth Management Services of South Carolina.