President Bush’s proposed tax break on dividend income for the “wealthy” has caused an uproar — especially from the liberal establishment. But if you consider federal, state, and local taxes on dividend income, investors — who are really owners — already pay about 70% on the earnings of the companies they own (corporate taxes and individual taxes combined). On this basis alone, investors need a break. However, what many investors really need is a break from low interest rates.
What’s that? You say that the Federal Reserve has never been more focused on stimulating the economy through a policy of pushing interest rates lower — and that’s great for investors? Well, that’s only partially true.
Easy money is supposedly good for stock investors. For fixed-income investors, it’s a different story. The Fed’s policy of lowering interest rates over the past two years has been devastating for many fixed-income investors and it hasn’t done much to stimulate the economy either. The real beneficiaries of easy money have been consumers who have taken advantage of record-low interest rates to load up on low-cost debt.
At the end of 2000, a conservative retiree who was investing in safe Treasury bills in his retirement-savings portfolio pulled down a reasonable 6% return. By the end of 2002, that rate had dropped to almost 1%. While aggressive stock investors moaned about losing 70% of their investment value in tech stocks, the most conservative investors lost more on a percentage basis of their income.
In early 2003, the average annual income on money market funds was only 0.83%! And that is before income taxes. When you multiply this example by the trillions of dollars invested in money market funds, CDs, and savings accounts, the investor, whether he is “wealthy” or just the little guy trying to live on a limited retirement budget, has taken an enormous beating on his interest income.
In total, I wouldn’t be surprised if that loss in income was well over $200 billion.
As long as interest rates stay low, the problem gets even worse for fixed-income investors. Each year, long-term notes and bonds — securities that have had much higher yields — mature. As investors reinvest at today’s yields, they will experience a dramatic drop in their income. Securities were issued with double-digit coupons back in the 1980s, and are set to mature in the early 2000s, but investors who originally bought these securities will experience a cut of 50% or more in income. When you consider the three-year bear market in stocks and the collapse in yields in the fixed-income market, there are few visible opportunities for investors to build wealth in U.S. financial markets. Maybe that’s one reason why consumer confidence continues to slide even though inflation remains at record lows.
The severity of this decline in investor income will not be easy to remedy. The Fed is still committed to stimulating business loans — even though falling credit ratings may preclude many banks from lending. The Fed also has said that it has plenty of room to stimulate — a statement that implies even lower interest rates in the future if the economy doesn’t rebound.
So, fixed-income investors cannot count on rising interest rates to help them out. Their only hope is for fiscal stimulus that improves after-tax income for investors. Now we see the importance of President Bush’s proposed tax relief for corporate dividends. While tax-free dividends won’t make a significant dent in the loss of income that fixed-income investors have suffered, it is a first step in the right direction.
Investors deserve a break. Opponents of the president’s plan just don’t get it.
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc., and an investment consultant for Wealth Management Services of South Carolina.