President Bush has surprised nearly everyone with his decision to propose a big-bang economic growth package that includes a 100% tax exemption on dividends received by individuals. Eliminating the double taxation of corporate dividends will raise stock market values, increase investor returns, and improve both corporate governance and corporate finance practices, in effect becoming the most significant pro-growth tax reform since President Ronald Reagan slashed personal income-tax rates twenty years ago.
This policy change will lower the effective tax rate on dividends paid from corporate profits to 35% from roughly 70%. Taxpayers receiving dividends will now keep 65 cents of each new dollar of corporate profits rather than the 30 cents they now retain under current tax law.
Since individuals and businesses spend and invest their money more wisely than government, this tax reform will make the economy more efficient and better able to grow to its potential. The move will also free up more investment resources for shareholders and corporations, thus making more funds available for entrepreneurship, business expansion, and job creation in the years ahead.
Investors, of course, will now demand greater dividend payouts from companies — a good thing. Cash dividends will be tax-free, while interest payments from corporate bonds will be taxed at the top personal rate (which could drop to 35% under the president’s new proposal). Shareholders will keep 100 cents on each new dividend dollar, compared with only 65 cents on each dollar of interest paid from corporate bonds. That will force corporations to reduce their issuance of new debt and rely more heavily on dividend-paying stock finance.
This tax-induced shift in shareholder demand from interest-bearing bonds to dividend-paying stocks will have wide-ranging benefits. It will stop firms from over-borrowing and debt leveraging up to their eyeballs — a practice that has worsened economic downturns and hastened business bankruptcies. And as the system of corporate funding better balances equity and debt, the business sector will grow healthier and the economy stronger.
Also, a new model of corporate governance will take hold. Just as taxpayers wish to keep more of what they earn from the government, tax-free dividend payments will encourage shareholders to demand more of what corporations earn. This will force companies to reduce their excess cash-on-hand and pay more money out to their shareholders.
In recent years too many CEOs have used corporate cash for ill-conceived acquisitions that all too often put empire-building over higher shareholder returns. Now boards of directors will pressure management to turn the cash over to investors. This change in corporate behavior will streamline operations and avoid the failed over-conglomeratization that sank stock market prices in the 1990s, especially in the telecom, media, and energy businesses.
Many firms, especially technology companies, will now be forced to start paying out their unnecessarily high cash balances to shareholders. Outfits like Microsoft, Cisco, and Dell will undoubtedly go down this road.
Additionally, investors will more often judge corporate creditworthiness on the basis of dividend yields (dividends divided by stock prices) instead of conflicted research reports. In fact, greater dividend payouts and yields will become the key benchmarks in judging the worth of stock investments.
All this should be a much-needed tonic for the major stock-market indexes. Since the current economic slump began in 2000, the stock-market decline has been the economy’s central problem. Shrinking market capitalizations have damaged corporate creditworthiness and frozen business operations. In all too many cases huge stock-market losses induced CFOs to play fast and loose with accounting ethics. Investor confidence evaporated as Worldcom, Enron, Tyco, Adelphia, and a list of others grabbed the headlines. So, last year was the first since 1912 that an early economic recovery was accompanied by a plunging stock market.
President Bush’s bold decision to eliminate the double taxation of corporate dividends will help restore investor confidence and the vitality of American businesses. Since business creates jobs, a healthier corporate sector is crucial to a full flushing-out of the nascent expansion.
The Bush administration’s new growth package will also include a speed up of income-tax cuts for all brackets, a substantial cash-expensing bonus for small business equipment write-offs, and a quicker implementation of child tax credits and marriage-penalty deductions. Democrats, of course, are dusting off their class warfare arguments, criticizing the Bush plan as another tax cut for the rich. But this is a content-less position that has failed miserably in recent elections.
The president has correctly understood his mid-term election mandate to grow the economy and win the war against terrorism. On the war front, he has proven his mettle since Sept. 11. And on the economy, he is clearly willing to invest his new political capital in pro-growth tax measures, as well as pro-market reforms for health care and prescription drugs. The nation will benefit enormously as he moves swiftly on all of these fronts.
— Mr. Kudlow is CEO of Kudlow & Co.