TCS Daily

Small Investors = Big Winners

By James K. Glassman - March 6, 2003 12:00 AM

Editor's note: The following is TCS Host James K. Glassman's testimony before a hearing on the President's Economic Growth Proposals before the Committee on Ways and Means of the U.S. House of Representatives. The Honorable William Thomas, chairman, was presiding.

Mr. Chairman and members of the Committee:

My name is James K. Glassman. I am a resident fellow at the American Enterprise Institute and host of the website In addition, for more than 20 years, I have been writing about personal investing as a columnist for The Reader's Digest, Worth magazine, the International Herald Tribune, New York Daily News and many other publications. I am currently a syndicated financial columnist for the Washington Post and am the author of two books on investing. The more recent, The Secret Code of the Superior Investor (Crown), was recently named one of the 10 best financial books of 2002 by Barron's.

A major focus of my work has been the impact of public policy, including tax policy, on small investors. With several associates, I am in the process of establishing a new organization that I will chair, Shareholders United, which will represent the interests of small investors.

Today, speaking only for myself, I will address the effects of President Bush's tax-reduction proposals, which I believe are highly beneficial. But, in order to assess the full impact of those proposals, it is first necessary to examine the sweeping changes that have occurred in the investment environment in the United States.

The Rise of the Shareholder Society

Over the past 20 years, personal investing has undergone a democratic revolution, creating what Robert J. Samuelson of the Washington Post called "one of the great social movements."1 In 1983, only 16 million households owned stocks - either as individual shares or through mutual funds. By 2002, the figure had climbed to 53 million households. In other words, roughly half the families in the United States are owners of American businesses listed on the major exchanges.2

Of all U.S. stockholders, 89 percent own at least some stocks through mutual funds, which are also vehicles for the ownership of bonds and other debt securities. The proportion of households owning mutual funds of any sort has risen has risen from 6 percent in 1980 to 50 percent in 2002.3

Ownership of financial assets has broadened dramatically. For example, the fastest-growing demographic sectors for mutual funds are: 1) families making between $25,000 and $35,000 a year, where the proportion of fund ownership went from 28 percent in 1998 to 36 percent in 2002, and 2) households headed by persons aged 25 to 34 years old, where fund ownership over the same period rose from 42 percent to 48 percent. Currently, 48 percent of households with incomes from $35,000 to $50,000 own mutual funds, as do 57 percent of households headed by a person aged 35 to 44.4

Similarly, a recent Federal Reserve report found that the median value of mutual funds held by non-whites and Hispanics in 2001 was $17,500; the value of stocks, $8,000; bonds, $7,600; and certificates of deposit, $9,000.6 The Fed data show that, for the average American family, financial assets now comprise 42 percent of total assets, compared with 32 percent 10 years ago.5

In other words, investing is no longer the exclusive domain of the white, the rich and the middle-aged.

Ownership of financial assets has continued to thrive despite the sharp decline in stock prices over the past three years.7 For example, the benchmark Standard & Poor's 500-Stock Index lost 9 percent of its value in 2000 and 12 percent in 2001, but the number of households owning mutual funds rose between January 1999 and January 2002 from 49 million to 53 million.8 Those are the most current ownership figures available, but we know that in 2002, investors withdrew a net of $27 billion from equity mutual funds - only about 1 percent of the total assets of those funds - despite the worst year for stocks since 1974. Investors also added a net of $140 billion to bond mutual funds.9

This revolution has brought a profound change: Americans no longer simply work for owners of capital assets; they are now owners themselves. "As capitalism expands," wrote my colleague Ben J. Wattenberg, "a lot of 'them' become 'us.' [Stock ownership] brings us all together as stakeholders in common."10 In 1977, the year before the 401(k) was created, there were 298 work stoppages that idled 1.2 million workers for 21.2 million working days. Twenty years later, there were only 29 strikes that idled 339,000 workers for 4.5 million working days.11 In addition to encouraging cooperation, ownership of financial assets "appears to have...encouraged an orientation towards the future - the investor's own and his family's."12

Tax Policy Encourages Broad Ownership of Financial Assets

A study by the Joint Economic Committee13 found that the main reasons for the broadening of ownership of financial assets were, first, the rise of mutual funds and, second, important changes in tax law, such as the advent of Individual Retirement Accounts and 401(k) accounts and the decline in capital-gains tax rates.

It [the IRA] was the first real incentive for a great number of Americans to put money away for the long term. And these were generally people who up until then hadn't seen themselves as having any control over the long-term.14

Still, the Tax Code continues to encourage consumption over savings and investment. "Taking the overall tax haul as given," The Economist magazine recently stated in an editorial, "America seriously overtaxes savings and seriously undertaxes consumption. This inhibits the accumulation of capital and probably depresses long-term growth. It also encourages excess indebtedness, which makes the economy more fragile."15

My perspective in this testimony, however, is not macroeconomic. It is from the bottom up - from the point of view of individual small investors.

Many of these investors wonder why they should save and invest beyond their 401(k) plans - and the majority of them do not even have such plans. Their salaries are first taxed at ordinary income rates; then, if they can save anything to invest in financial assets, the income (dividends and interest) from those investments are also taxed at ordinary rates; if they re-invest what is left of that income after taxes, the dividends and interest are taxed once more. If they sell the assets at a profit, capital gains taxes apply. And if they manage to pass along any of their investments at death, then estate taxes may apply. Americans wonder why they shouldn't consume (in which case, they're taxed only once, on the initial salary) rather than save and invest.

The Bush Tax Plan

In January, President Bush announced a tax plan to speed up the recovery from the 2001 recession, provide an economic insurance policy against war and terror, and strengthen the economy for the long term. The two most significant features were ending the double-taxation of corporate dividends and making rate reduction from the 2001 tax law effective immediately rather than phasing them in (in 2004 and 2006, as the law originally provided). Both of these measures will encourage savings and investment and broaden the shareholder society - not by bestowing special favors but by removing impediments.

Double Taxation of Dividends

The dividend proposal addresses an anomaly in the tax law. Suppose a company earns $1 in profits that it wants to pass on to its owners, that is, its public shareholders. The $1 is first taxed at the corporate level at a rate of around 40 percent, including both federal and state corporate income taxes. That leaves 60 cents. The 60 cents is then sent to shareholders in the form of dividends. The shareholders pay, depending on their tax bracket, taxes that are fairly similar - in many cases, 40 percent or more. That leaves 36 cents. So, of the original $1 in profits, 64 cents go to taxes.

The idea of eliminating one of the layers of taxation is not a new idea. In fact, it was embraced as long ago as 1936 by President Franklin D. Roosevelt, whose Treasury Secretary, Henry Morgenthau, proposed ending taxes on income at the corporate level for all profits that were distributed to shareholders.16 Roosevelt said that the measure "would constitute distinct progress in tax reform." It ultimately failed, of course. The Bush proposal retains taxes at the corporate level but eliminates them at the individual level. The effect is the same.

Double taxation creates serious economic distortions. For example, it encourages companies to borrow (since profits that are used to pay interest on debt are taxed only once, not twice), and it encourages them to retain their earnings rather than paying them out to shareholders. Since current tax policy promotes such inefficiencies, it hurts small investors by depleting the value of their holdings.

In recent years, the effects have been dramatic - in part because the gap between capital gains rates (now up to 20 percent) and ordinary income rates (now up to 38.6 percent) has risen. For example, in 2002, only 351 companies paid any dividend at all, among the 500 large firms that comprise the S&P 500.17 That is the lowest proportion on record. More important, the percentage of profits that the average firm sends to shareholders in the form of dividends has fallen from 55 percent to 36 percent over the past two decades.18

Dividend payments mean less volatility for investors. Even in a year in which a stock might fall 20 percent in price, a stock is likely to continue paying its dividend, providing steady income and a buffer against capital losses.

In addition, academic research, starting with the work of Michael Jensen of Harvard in 1986, indicates strongly that "the more cash that companies have now (beyond what is needed for current projects), the less efficient they will be in the future."19

In 2002, the stocks of S&P 500 companies that paid dividends fell 13.3 percent, on average, while the stock non-dividend payers declined 30.3 percent.20 While this difference is particularly extreme, it is clear that companies that keep their cash often use it unwisely. A new study by Robert Arnott and Clifford S. Asness has found:

For the overall stock market between 1871 and 2001, corporate profits grew fastest in the 10 years following the calendar years in which companies had the highest average dividend payout ratio. In contrast, the 10-year real earnings growth rate was the lowest following years with the lowest average payout ratio.21

The authors believe that "the primary cause" of this result is "the poor job that the average company does when investing the cash that it would pay out as dividends. Therefore, it is better for the company to distribute its earnings to shareholders."22

Currently, managers have an excuse and an incentive to hoard their earnings. In fact, it is surprising that they pay out even one-third of their profits to shareholders, considering the tax laws. But eliminate double taxation of dividends and the excuse disappears. The proposal "would encourage more corporations to distribute dividends or, at least, disclose in greater detail whey they choose not to - a point worth the attention of those demanding greater managerial accountability in the use of what Louis Brandeis called 'other people's money.'" 23

Consider a company that earns $4 per share in profits after taxes. It retains $2 for reinvesting in the business and sends $2 to shareholders in the form of dividends. The shareholders can then choose: reinvest in the company themselves because they like what management is doing, or use the money to invest in another company. Without the dividend, the only action the shareholder can take is to sell his or her stock altogether.

A dividend is also, in most cases, a more accurate manifestation of a company's financial health than the paper profits reported to government authorities. An old saying, going back to at least the 19th century, holds that "earnings are opinion, but cash is a fact." I continually encourage my readers to look at the consistency with which a company pays - and raises - its dividend. Such activity tells far more about the soundness of the firm than rising earnings, which, as we have seen, are easy to manipulate. Dividends can't be faked. It's true that companies can borrow to pay dividends, but under the president's proposal, such leveraged dividends are taxable to investors - a sure sign that something fishy is going on.

Consider Enron Corp. Between 1997 and 2000, Enron increased its reported earnings per share by a total of 69 percent (from 87 cents to $1.47), but its dividends per share rose only 9 percent (from 46 cents to 50 cents).24 That might have been a tip-off that the company was suffering a cash squeeze. But investors ignored the evidence, in part because they simply have not taken dividends very seriously in recent years, thanks to the tax disincentives. That will change if the Bush proposal becomes law.

Almost exactly a year ago, I testified in front of the House Financial Services Committee in a hearing whose subject was, "How to Protect Investors Against Another Enron." I stated at the time:

Cash dividends are the clearest, most transparent evidence of corporate profits. An investor who sees dividends increasing every year can, properly, have confidence in a company.... Ending double taxation of dividends would increase payouts and vastly increase investor confidence. I realize that this matter goes beyond the committee's jurisdiction, but it is probably the single most important legislative step that can be taken to protect shareholders.25

Beyond corporate governance, ending the double taxation of dividends will have a powerful and beneficial effect: It will increase the return on every small investor's stock investments. The White House estimates that 35 million Americans currently receive taxable dividends and will benefit from the changes. Half of those Americans are senior citizens.26

Consider a person in a 30 percent tax bracket who owns 100 shares of stock in a company that currently pays a dividend of $1 per share. Assume the dividend payout does not increase. Under current law, the investor pockets $70 after taxes; if the Bush proposal passes, the investor pockets the full $100. That is an increase of 43 percent. Now assume that the company, as a result of the new tax incentive, boosts its payout from $1 to $1.25 - which is actually a more modest increase than would occur if the current payout ratio merely reverted to the mean of previous decades. Now, the investor pockets $125 instead of $70 - an increase of 79 percent.

But what about investors who hold stock in tax-deferred accounts or in Roth IRAs, which are untaxed? Almost certainly, such investors would benefit from a rise in the price of the shares themselves since each of those shares would now produce more after-tax income for taxable investors. Those investors would bid up the share price. How much? Economists differ, but a rise in price is undeniable.

Perhaps more important, eliminating the double taxation of dividends would provide an incentive for investors to increase their savings outside limited tax-advantaged vehicles like 401(k) plans and IRAs, decreasing their dependency on Social Security and encouraging them to put money aside for non-retirement expenses, including education, home purchases and renovation, travel or starting their own businesses.

At the very least, the proposal turns the attention of investors toward dividends, which in recent years have not received the respect they deserve. While dividends have declined as a percentage of stock prices (yield), they remain a critical factor in achieving high returns over time. For example, a study found that $1,000 invested in the S&P 500 index on June 30, 1982, became $16,597 (without taxes) by Sept. 30, 2001. But approximately 40 percent of those gains came from reinvesting dividends back into the stocks of the index.27

Acceleration of Rate Reductions

In 2001, Congress passed and the President signed into law a bill that reduced tax rates across the board. In fact, proportional cuts were greater at the low end than the high. The bottom rate was cut to 10 percent from 15 percent (a decline of one-third) while the top rate was cut from 39.6 percent to 35 percent (less than one-eighth). In addition, the cut to 10 percent happened immediately while other rates were scheduled to be reduced slowly, with completion by 2006. In an effort to boost the recovery, the President has proposed making all remaining cuts effective now, retroactive to Jan. 1, 2003.

By accelerating the tax-rate reductions, the proposal would increase the current income that small investors receive from their financial assets, both equities and debt. Some of the increased income would be consumed in purchases of goods and services and some would go back into investment. But the overall effect would be to increase the incentives for future investment by increasing returns at the margin - that is, at the point of deciding how to commit a dollar in hand.

Again, the math is simple. Take an investor in a 39.6 percent tax bracket before the 2001 law. The rate is now 38.6 percent, but, if the President's proposal is accepted, the investor's rate drops immediately to 35 percent. If she had invested a few years ago in a $10,000 Treasury bond paying 6 percent interest, she will this year, if the law does not change, receive $600 before taxes and $368.40 after taxes. With the acceleration, she will pocket $390 - an increase of 6 percent. Another way to say this is that her after-tax return on the investment will rise from 3.7 percent to 3.9 percent. That's a significant increase in a low interest-rate environment. Similarly, an investor who is trying to decide what to do with $10,000 will have more incentive to invest than to consume since returns are higher.

Two objections are frequently raised. The first is that the benefits of acceleration go to higher earning Americans. Proportionally, the opposite is true. The bottom bracket gets the biggest cut; the other brackets get roughly the same cut. In terms of actual dollar savings, of course, the higher-earners will, in many cases, get more, but the tax plan offers other cuts aimed at middle-income Americans including remediation for the "marriage penalty" and higher child credits. As an example, the Treasury cites "a married couple with two children and income of $60,000." Such a family will see taxes decline under the President's proposal "by $900 (from $3,750 to $2,850) in 2003, a decline of 24 percent."28

As for the highest earners getting more dollar savings: The latest Internal Revenue Service data show that the top 5 percent of taxpayers (with incomes above $121,000) pay 56 percent of all individual income taxes - even though they earn only 34 percent of all income. By contrast, the 50 percent of taxpayers with the lowest incomes (below $26,000) pay just 4 percent of the individual income taxes - with 13 percent of all income.29 Any across-the-board cut, or even a cut skewed toward lower earners, will by necessity produce large savings for higher earners.

Higher earners are also more likely to save and invest. But low- and middle-income Americans need incentives, too. According to the Fed, in 2001, the median family in the 90th to 100th percentile of income held $161,000 in unrealized capital gains (that is, stock and bond profits), up from $75,000 in 1995. (That 2001 figure is probably lower now, with the decline of the stock market, but it is still substantial.) By contrast, the median family in the 40th to 60th percentile held just $9,500 in unrealized capital gains, up from $4,300 but still a minuscule number.30

The President's proposals will almost certainly boost the economy, adding to the value of the stock holdings of more than 50 million American families and spurring more capital investment and job creation. But, just as important, they will encourage families to make prudent purchases of financial assets - stocks and bonds for the long term - to provide them with more comfortable and fruitful lives.

Using static accounting methodology, the tax cuts represent less than one-half of one percent of the Gross Domestic Product that the U.S. is expected to generate over the next 10 years. That is a small price to pay for stronger growth, more jobs, and sounder retirements.

Thank you.

1. Robert J. Samuelson, "Stocks Without Risks?" Newsweek, Nov. 11, 1999.

2. "Equity Ownership in America," 2002, report based on several data sources, including the Investment Company Institute and the Securities Industry Association. Published by the American Council for Capital Formation, Washington, October 2002. See

3. "U.S. Household Ownership of Mutual Funds in 2002," Investment Company Institute, Washington, October 2002. See

4. Ibid.

5. "Recent Changes in U.S. Family Finances: Evidence from the 1998 and 2001 Survey of Consumer Finances," Federal Reserve Board, p. 13. See

6. Ibid, p. 9.

7. 2000-2002 comprised the third-worst three-year period in stock market history. The broad market index dropped 40 percent, a figure exceeded only by 1930-1932 and 1929-1931.

8. S&P figures from 2002 Yearbook, Ibbotson Associates, Chicago. Ownershp data from "Equity Ownership," op. cit..

9. "Trends in Mutual Fund Investing," December 2002, Investment Company Institute statistics; press release, Jan. 30, 2003.

10. Ben J. Wattenberg, "Capitalism for the Masses," Baltimore Sun, Jan. 9, 1997.

11. "Investor Fact Sheet," American Shareholders Association, Washington. See

12. Richard Nadler, "The Rise of Worker Capitalism," Cato Policy Analysis No. 359, Nov. 1, 1999.

13. "The Roots of Broadened Stock Ownership," Joint Economic Committee, April 2000. See

14. Joseph Nocera, A Piece of the Action: How the Middle Class Joined the Money Class (New York, 1994), p. 288.

15. "Who dares wins," The Ecomonist, Jan. 11, 2003, p. 10.

16. A fascinating discussion of FDR's advocacy of ending double taxation of dividends is found in a memorandum to "Friends of ABC," the American Business Conference, Washington, D.C., by John Endean, who himself draws from John M. Blum, From the Morgenthau Diaries, Volume One: Years of Crisis, 1928-1938 (Boston, 1959), pp. 305-319.

17. "2002 Review," Standard & Poor's, U.S. Indices, p. 4.

18. The average dividend payout ratio (dividends/earnings) for stocks covered by the Value Line Investment Survey was 55 percent between 1977 and 1986 and 36 percent for 2000, the most recent year for statistics. The decline has been consistent and dramatic. "A Long-Term Perspective: Dow Jones Industrial Average 1920-2000," Value Line Publishing, Inc., New York.

19. Michael C. Jensen, "The Agency Costs of Free Cash Flow: Corporate Finance and Takeovers," American Economic Review, Vol. 76, No. 2 (May, 1986). The quotation is not from the paper, but from a paraphrase by Mark Hulbert, "In a Twist, High Dividends Are Now a Predictor of Growth," New York Times, Nov. 17, 2002.

20. "2002 Review," Standard & Poor's, op. cit.

21. Hulbert, op. cit.

22. Ibid.

23. Endean, American Business Conference, op. cit.

24. Data from Value Line's final one-page analysis of Enron, by Sigourney B. Romaine, Dec. 21, 2001. Also worth nothing is that Enron's cash flow was negative (that is, capital expenditures, not to mention dividends, exceeded incoming cash) for each of the years 1997-2000. The Value Line Investment Survey, New York.

25. James K. Glassman, "How to Protect Investors Against Another Enron," testimony before a hearing on H.R. 3763, "The Corporate and Auditing Accountability, Responsibility and Transparency Act of 2002," Financial Services Committee, U.S. House Of Representatives, March 13, 2002.

26. "Fact Sheet: The President's Proposal to end the Double Tax on Corporate Earnings," U.S. Department of the Treasury, press release, Jan. 14, 2003. See

27. "Fading Dividends Could Make a Comeback," T. Rowe Price Report, Baltimore, Fall 2001, p. 6.

28. "Examples of Tax Relief in 2003 Under the President's Growth Package," U.S. Department of the Treasury, op. cit.

29. "Tax Bites," table of Federal Individual Income Taxes by Income Class,Tax Foundation, Washington, D.C.,

30. "Recent Changes in U.S. Family Finances," op. cit., p. 20.


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